Fact, Fiction, and Value Investing

CLIFFORD ASNESS, ANDREA FRAZZINI, RONEN ISRAEL AND TOBIAS MOSKOWITZ

Abstract

Value investing has been a part of the investment lexicon for at least the better part of a century.

In particular the diversified systematic “value factor” or “value effect” has been studied extensively since at least the 1980s. Yet, there are still many areas of confusion about value investing. In this article we aim to clarify many of these matters, focusing in particular on the diversified systematic value strategy, but also exploring how this strategy relates to its more concentrated implementation. We highlight many points about value investing and attempt to prove or disprove each of them, referencing an extensive academic literature and performing simple tests based on easily accessible, industry-standard public data.

Introduction

While recently confronting the myths surrounding momentum investing1 we discovered two things: 1) there is as much confusion about value investing and 2) if one debunks the mythology around momentum investing some will get the wrong impression that defending momentum means denigrating value. Even experienced investors often seem to wrongly assume one cannot simultaneously believe in both value and momentum investing.

Value is the phenomenon that securities which appear “cheap” on average outperform securities which appear to be “expensive.” The value premium is the return achieved by buying (being long in an absolute sense or overweight relative to a benchmark) cheap assets and selling (shorting or underweighting) expensive ones. The existence of the value premium is a well-established empirical fact: it is evident in 87 years of U.S. equity data, in over 30 years of out-of-sample evidence from the original studies, in 40 other countries, in more than a dozen other asset classes,2 and even dating back to Victorian age England!3

Importantly, our definition of “value investing” is the highly diversified “academic” (though many practitioners follow it also) version of value, not concentrated value-based stock picking (which we discuss further in one of our sections). In addition, our starting point is “pure” value, price vs. some fundamental like book value, based solely on quantifiable measures and not adjusted for other qualities (a distinction which we will also address in this paper). For example, by our definition, a “pure” value investor only looks to purchase low price-to-book stocks.

Adjusting for other qualities” means you are willing to pay more, accept a higher price-to-book, for faster growers, more profitable firms, or any other quality you desire (some call this “growth at a reasonable price” though obviously we are generalizing beyond just growth). The interplay between “pure value” and value considering other qualities will come up a few times in the paper.

Value strategies have had a long and storied history in financial markets. They are often credited to Benjamin Graham and David Dodd dating back to the late 1920s, who advocated a form of value investing by buying profitable but undervalued assets (a double condition we will soon see to be an important distinction from what we call “pure value”). Indeed, value investing has been considered an important part of the equity investment landscape for the better part of the last century, and while undocumented, we would assume for far longer (somewhere there must have been a Roman saying “I came, I saw, I purchased at a low multiple”). However, despite all of this, there still remains much confusion about value investing. Some of this confusion is propagated by value’s opponents in an attempt to disparage the strategy, but others are often,

  1. Fact, Fiction, and Momentum Investing,” Journal of Portfolio Management [2014], 40th Anniversary edition.

  2. See Asness et al. [2013].

    See Chabot, Ghysels, and Jagannathan (2015), who show evidence of a value effect using dividend yield in U.K. stocks going back to the 1860’s.

intended or not, also perpetuated by those explicitly or implicitly advocating it (there is even one notable case of a clear pure value investor who claims not to be!).

Our paper is organized by identifying a number of facts and fictions about value investing that need clarification. The facts we present include showing that value works best with other factors, which can still be consistent with risk-based explanations for value, that it is best measured by multiple variables (rather than a single variable such as book value relative to market value), that it is exactly what the recently popular investing approach called “Fundamental Indexing” does, and that it is a weak effect among large cap stocks (especially relative to other factors that hold up in both large and small caps). The fictions we will attempt to clarify include the false notions that value investing is only effective in concentrated portfolios, that it is a “passive” strategy, that it is a redundant factor in the face of newly emergent academic factors (namely, Fama and

French’s new investment and profitability factors), and that it is only applicable in a stock picking context. Finally, we will take on the commonly held belief that value is solely compensation for risk yet somehow not a scary strategy and that a continued value premium in the future can only be consistent with an efficient markets view of the world. We certainly do not reject efficient markets, but value’s success can occur in a world of efficient markets, inefficient markets, or the likely truth that lies somewhere in-between, all of which are subject to time variation and hard to envision disappearing.

While our prior paper on momentum was an attempt to address and refute the myths and public criticisms hurled at momentum investing, this paper instead tries to present some facts and clarify some misconceptions surrounding value investing, a somewhat softer goal befitting a more “occasionally confused” than “attacked” strategy. As in the prior paper, we address the facts and fictions of value investing using published and peer-reviewed academic papers and conduct tests using the most well-known and straightforward publicly available data (most of which come from Kenneth French’s website as detailed in the appendix) in U.S. equity markets.4

Finally, the topics we address will include both positive and negative attributes of value investing. We consider ourselves, and have for many years, among value investing’s strongest proponents, particularly when used in combination with some other factors (like momentum and, more recently, profitability). Our discussion is not at all meant to denigrate a strategy that we believe is a corner-stone of good investing. Instead, it is merely to see the pros, cons, and even ancillary beliefs more clearly.

Now, on to the main event.

Fiction: Value investing can only be successfully implemented with a concentrated portfolio.

As we discussed in the introduction, in this paper we will explore the highly diversified, systematic version of “value investing”, not concentrated value-based stock picking. Yet, to be a successful value investor don’t you have to apply value in a concentrated portfolio, deeply understanding each and every security in order to uniquely identify cheap stocks? Warren Buffett certainly thinks so. To quote Mr. Buffett: “Diversification is protection against ignorance. It makes little sense if you know what you are doing.”

As Mr. Buffett himself states, his common investment theme is to find “discrepancies between the value of a business and the price of that business in the market.” He applies this philosophy to a handful of stocks that he deeply investigates and understands, holding them in a concentrated portfolio for the long-term. He’s obviously done it incredibly well.

But, Benjamin Graham, who Buffett credits as a mentor for his investment training, actually believed in the long term evidence in favor of a diversified portfolio as opposed to one based on a few concentrated positions. In The Intelligent Investor (revised in 1973) he writes “In the investor’s list of common stocks there are bound to be some that prove disappointing… But the diversified list itself, based on the above principles of selection, plus whatever other sensible criteria the investor may wish to apply, should perform well enough across the years. At least, long experience tells us so.”

Still, does the existence of Warren Buffett and his long-term incredible performance prove that an idiosyncratic value process dominates a systematic one? As the saying at the University of

Chicago goes, “the plural of anecdote is not data.” Warren Buffett is to value investing what George Burns, the comedian who lived to 99 years of age while smoking 10 to 15 cigars a day for 70-plus years, is to the health effects of smoking.5 Should we ignore the evidence that statistically you are at greater mortality risk from smoking based on George Burns? Unless you are the magazine Cigar Aficionado,6 the answer is clearly, no. For value investing, there is strong long-term evidence from a wide variety of assets that a systematic value strategy can deliver good long-term returns. The fact that Warren Buffett was able to successfully pick individual cheap stocks should not derail that notion. Being Warren Buffett is nice work if you can get it, certainly after-the-fact. But, the legion of academic and practitioner evidence is that diversified portfolios of “cheap” (on pure value measures) securities healthily outperform their more

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