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Larry Swedro

Swedroe: Value Premium Lives!

Re-posted from Swedroe: Value Premium Lives!

There has been much debate about the “death” of the value premium. Those making the case it has disappeared believe the publication of research on the premium has led to cash flows, which in turn have eliminated it.

They point to the last 10 calendar years of data, during which the value premium was slightly negative, at -0.8%. The value premium (HML, or high minus low) is the annual average return on high book-to-market ratio (value) stocks minus the annual average return on low book-to-market ratio (growth) stocks.

Before taking a deeper dive into the data, it’s important to note that all factor premiums, including market beta, have experienced long periods of negative returns. The following table, covering the period 1927 through 2017, shows the odds (expressed as a percentage) of a negative premium over a given time frame. Data in the table is from the Fama/French Data Library.

1-Year 3-Year 5-Year 10-Year 20-Year
Market Beta 34 24 18 9 3
Size 41 34 30 23 15
Value 37 28 22 14 6
Momentum 28 16 10 3 0

 

No matter the horizon, the value premium has been almost as persistent as the market beta premium. Even the market beta premium has been negative in 9% of 10-year periods and in 3% of 20-year periods.

Changing Regimes

Investors who know their financial history understand that what we might call “regime change,” with value underperforming for a fairly long time, is to be expected. In fact, even though the value premium has been quite large and persistent over the long term, it has been highly volatile. According to Ken French’s data, the annual standard deviation of the premium, at 12.9%, is 2.6 times the size of the 4.8% annual premium itself (for the period 1927 through 2017).

While 10 years may seem like an eternity to most investors (even institutional investors fire managers after a few years of underperformance), it can be nothing more than noise. Having to remain disciplined over such long periods is perhaps why Warren Buffett famously said that investing is simple, but not easy.

As Andrew Berkin and I point out in our book, “Your Complete Guide to Factor-Based Investing,” investors should have confidence in the value premium because it has been persistent across long periods of time and various economic regimes and has been pervasive around the globe and across asset classes. In addition to stocks, a value premium has existed in bonds, commodities and currencies (in other words, buying what is cheap has outperformed buying what is expensive).

Furthermore, the value premium has been robust to various definitions, not just the price-to-book (P/B) measure, or HML, popularized by Fama and French. Indeed, the premium is also found when using other value metrics, such as price-to-earnings (P/E), price-to-cash flow (P/CF), price-to sales (P/S), price-to-earnings before interest, taxes, depreciation and amortization (P/EBITDA), price-to-dividend (P/D) and price to almost anything—however it’s measured, cheap has outperformed expensive.

With that in mind, we can look at the size of the value premium for the 10-year period ending 2017 against some of those other metrics (all data is from Ken French’s website). While the value premium was negative by P/CF (-1.2%) and slightly negative by P/B, it was actually positive using P/E (1.2%) and P/D (0.6%)—so, on average, about zero.

Before moving on, it’s important to note many have questioned the sole use of P/B as the best value metric, especially in an age when many assets are now intellectual capital that often don’t appear on balance sheets (externally acquired intangibles do appear on balance sheets).

Reasons not to believe P/B—or for that matter, any single metric—is the superior measure of value include the fact that one metric could work better than others do for some industries, and various metrics have provided the highest premium in different economic regimes. That is why many practitioners and mutual fund families now use multiple metrics, which I believe can provide a diversification benefit.

Value’s Performance

Having covered that ground, let’s go to our trusty videotape and see how value performed outside the U.S. If value is “dead,” we should find confirming evidence in other markets.

The following table—again, using data from Ken French’s website—shows the premium for the 10 years from 2008 through 2017 in international developed markets.

 

2008-2017 Average Annual Premium (%)
Int’l B/M 1.9
Int’l E/P 4.1
Int’l CF/P 2.5
Int’l D/P 3.1

 

No matter which metric I use, there was a value premium in developed international markets. This result actually surprised me, because research shows value stocks are more exposed to economic cycle risks—they perform best in periods of stronger economic growth because they become less risky. While the last 10 years saw the slowest economic recovery in the post-World War II era, economic growth has been even more anemic in the non-U.S. developed world.

Having shown the value premium in international markets has been fairly similar to historical levels, I can also examine live results.

Specifically, I’ll compare the returns of the passively managed, structured international value funds my firm uses with those of marketlike ETFs in three asset classes. Data is from Morningstar and covers the 10-year period ending May 4, 2018. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends Dimensional funds in constructing client portfolios.)

 

Funds 1-Yr Return
International Large
iShares MSCI EAFE ETF (EFA) 2.25%
DFA International Value Portfolio III (DFVIX) 2.20%
International Small
iShares MSCI EAFE Small-Cap ETF (SCZ) 6.05%
DFA International Small Value (DISVX) 5.89%
Emerging Markets
iShares MSCI Emerging Markets ETF (EEM) 1.29%
DFA Emerging Markets Value (DFEVX) 1.66%

Note: Dimensional’s international strategies include Canada; EAFE indexes do not.

 

The average return of the three ETFs was 3.20%. The average return of the three Dimensional value funds was 3.25%. Thus, while there was a value premium, compound returns were no better (as the roughly 2-3% higher annual volatility of value stocks negatively affected their compound returns), but no worse, either.

One way to look at the results is that, over one of the worst 10-year periods for the performance of value stocks, value investors were not “penalized” for their strategic decisions. Another is to believe the value premium is dead.

 

My view is that there is a large body of evidence demonstrating logical, risk-based explanations for the value premium. While cash flows can shrink premiums, risk-based premiums cannot be arbitraged away. On the other hand, it’s possible to arbitrage away behavioral-based premiums, such as momentum (though limits to arbitrage often prevent this from occurring).

Among the risk-based explanations for the premium are that value stocks contain a distress (default) factor, have more irreversible capital, have higher volatility of earnings and dividends, are much riskier than growth stocks in bad economic times, have higher uncertainty of cash flow, and, as previously mentioned, are more sensitive to bad economic news.

Given these risk-based explanations, it is hard to believe the value premium can be arbitraged away. With that understanding, let’s consider whether cash flows have eliminated the premium.

Relative Valuations

If, as many people believe, the publication of findings on the value premium has led to cash flows that have caused it to disappear, we should have seen massive outperformance in value stocks as investors purchased those equities and sold growth stocks.

Yet the last 10 years have witnessed the reverse in terms of performance. In addition, if cash flows had eliminated the premium, the buying of “undervalued” value stocks and selling of “overvalued” growth stocks should have led to a reduction in the valuation spreads between value stocks and growth stocks.

I happen to have kept a table from a seminar Dimensional gave in 2000. It shows that, at the end of 1994, the P/B ratio of large growth stocks was 2.1 times as big as the P/B ratio of large value stocks.

Using Morningstar data, as of May 3, 2018, the iShares S&P 500 Growth ETF (IVW) had a P/B ratio of 4.7, and the iShares S&P 500 Value ETF (IVE) had a P/B ratio of just 2.0—the spread has actually widened from 2.1 to 2.4. Thus, value stocks are cheaper today, relative to growth stocks, than they were shortly after Fama and French published their famous research.

We can also look at the P/E metric. In 1994, according to the Dimensional table, the ratio of the P/E in large growth stocks relative to the P/E in large value stocks was 1.5. As of May 3, 2018, and again using Morningstar data, IVW had a P/E ratio of 20.0, and IVE had a P/E ratio 14.4. Thus, the ratio, at 1.4, was almost unchanged. There’s no evidence here that cash flows have eliminated the premium.

We see similar results when we look at small stocks. The Dimensional data shows that, at the end of 1994, the P/B of the CRSP 9-10 (microcaps) was 1.5 times as large as the P/B of small value stocks. Using Dimensional data, and the firm’s microcap fund (DFSCX) for microcaps and its small value fund (DFSVX) for small value stocks, as of April 30, 2018, the ratio of the funds’ respective P/B metrics was the same 1.5 (1.9÷1.3). When we look at P/E, again, the results are similar. At the end of 1994, the ratio of those funds’ respective P/E metrics was 1.2; it is now the same 1.2 (20.2÷16.3). Again, I see no evidence that cash flows have eliminated the premium.

Using data from Ken French’s website, we also see similar results when we look at the period starting in 2008. In 2008, the ratio of the P/B of U.S. growth stocks (4.8) to U.S. value stocks (1.1) was 4.4. By the end of 2017, the ratio had increased to 5.3 (6.3÷1.2), the opposite of what you would expect if cash flows had eliminated the premium.

Conclusion

Based on the logical, risk-based explanations for the value premium, and the lack of evidence pointing to shrinking valuation spreads, my conclusion is that the most recent 10 years of performance is likely just another of those occasionally occurring but fairly long periods in which the value premium is negative. If periods such as these did not occur, there would be no risk, and no risk premium. This is true of all risky investments, including stocks (and thus the market beta premium).

The bottom line is that, at least in my opinion, it’s hard to conclude the value premium is dead. Being able to stay the course during long periods of relative underperformance is what led Warren Buffett to assert that successful investing has a lot more to do with temperament (meaning discipline and patience) than intellect.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

Teresa Staker
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Dimensional

LETTER FROM THE CHAIRMAN, 2017

After more than 35 years in the financial services industry,
I have found that having an investment philosophy—one that
is robust and that you can stick with—cannot be overstated.

Just like a personal philosophy can act as a moral compass, an investment philosophy can guide your decisions on how to invest. While this may sound simple, the implications can be significant. People who
put their savings to work in capital markets do so with the expectation of earning a return on their investment, and there is ample evidence to support that long-term investors have been rewarded with such returns. But we also know that investors will encounter times when the results are disappointing. It is in these times that your philosophy will be tested, and being able to stay the course requires trust.
The alternative approach likely consists of moving between different strategies based on past results, which is unlikely to lead to a good outcome.  At Dimensional, our investment philosophy is based on the power of market prices and guided by theoretical and empirical research.

What does that mean?

Markets do an incredible job of incorporating information and aggregate expectations into security prices, so it does not make sense to form an investment strategy that attempts to outguess the market. Our approach focuses on using information contained in prices to identify differences in expected returns. We conduct research to help us organize our thinking, improve our understanding of what drives returns, and gain insights on how to build sensible portfolios. One such insight is looking beyond average returns. By considering the entire distribution of outcomes, we can better understand what investors should be aware of to help them stay invested when results aren’t what they expect.  As an example, the S&P 500 Index has returned about 10% annualized since 1926. But over that time period, there the S&P’s return was within two percentage points of 10%.1 If investors were to adopt a strategy that tracks the S&P 500 Index expecting 10% each year, they need to understand that returns over any given period can look different.

So what does it take to stay the course? Our view is that while there is no silver bullet, there are some basic tenets that can help. Developing an understanding of how markets work and trusting markets is a good starting point. Having an asset allocation that aligns with your risk tolerance and investment goals is also valuable. We believe financial advisors can play a critical role in this determination. Finally, it’s important that the investment manager can be trusted to execute the desired strategy.  In this regard, an index-like approach is useful because of how transparent it is.

It is easy for an investor to examine whether the returns achieved by the manager matched those of the index. This is part of the reason indexing has been a positive development for investors, offering a transparent, low-cost way to access markets. However, index funds prioritize matching an index over potentially achieving higher returns—so we believe they are too mechanical.

So what does it take to stay the course? Our view is that while there is no silver bullet, there are some basic tenets that can help. Developing an understanding of how markets work and trusting markets is a good starting point. Having an asset allocation that aligns with your risk tolerance and investment goals is also valuable. We believe financial advisors can play a critical role in this determination. Finally, it’s important that the investment manager can be trusted to execute the desired strategy.

In this regard, an index-like approach is useful because of how transparent it is.  It is easy for an investor to examine whether the returns achieved by the manager matched those of the index. This is part of the reason indexing has been a positive development for investors, offering a transparent, low-cost way to access markets. However, index funds prioritize matching an index over potentially achieving higher returns—so we believe they are too mechanical.

At Dimensional, we’ve sought to improve upon indexing, taking the best of what it offers and adding the ability to make judgments. Our experience has been that by incorporating a little bit of judgment, you can add a lot of value.

Dimensional began back in 1981 with a new idea: small cap investing. The premise was that many investors didn’t invest in small cap stocks, and that small caps behaved differently than large cap stocks and could offer diversification benefits to investors concentrating in large caps. We found clients who agreed the idea was sensible. Over the next nine years, the performance of small cap stocks was disappointing relative to large caps (at one point the S&P 500 outpaced our portfolio by about 10% annually), so on the surface it may have appeared that both we and our clients had a reason to be nervous. But clients were willing to stick with us because we were clear about our objective—providing a diversified portfolio of small cap stocks—and we delivered on it.2 Having compelling ideas is important, but the implementation of those ideas is what really counts. From the beginning, we focused on developing protocols about how to design and manage portfolios, and 35 years later we have amassed a track record of results that we believe stands out in the industry.

————————————————————————————————————————

1. Past performance is not a guarantee of future results. Indices are not available for direct
investment; therefore, their performance does not reflect the expenses associated with the
management of an actual portfolio. The S&P data is provided by Standard & Poor’s Index Services
Group.
2. Diversification does not eliminate the risk of market loss. Investing risks include loss of
principal and fluctuating value. Small cap securities are subject to greater volatility than those
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Relative Performance of Equity Funds with More than 15 years of History

While our long-term results show an ability to add value over benchmarks, we still place tremendous value on helping our clients understand why we do what we do. Just like those first years, we have lived through other times when the results have looked disappointing. This is one reason our approach combines our ability to make judgments with the transparency we believe is necessary for clients to understand what they can expect from us. The solutions we provide are meant to help clients achieve their financial goals. We know that a big part of enjoying the expected benefit of long-term returns relies on the ability to stay invested. By clearly articulating what we promise to provide, and delivering on those promises with robust portfolios, our hope is that we can help increase clients’ confidence in their decision to invest with us and provide them with a more successful investment experience.
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Letter from the Chairman 2017 Signature

DAVID BOOTH
Founder and Executive Chairman
DIMENSIONAL FUND ADVISORS

LETTER FROM THE CHAIRMAN, 2017

Appendix Letter from the Chairman