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

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