The Viability of the Value Premium Part II: Historical ContextSubmitted by Desmond Wealth Management, Inc. on August 11th, 2019
In our last message, we launched our five-part series exploring the ongoing viability of the value premium. After enduring approximately a decade of disappointing U.S. value stock returns, even disciplined investors may be wondering whether this factor will continue to deliver its expected premium in the future.
To support our continued faith in value investing, we begin by describing its historical roots. In 1992, professors Eugene Fama and Ken French published a landmark study in The Journal of Finance, “The Cross-Section of Expected Stock Returns.” Their work gave birth to the Fama/French three-factor model, which suggested three sources of expected returns could explain almost all of the differences in returns among different portfolio builds:
- The equity premium – Stocks (equities) have returned more than bonds (fixed income).
- The small-cap premium – Small-company stocks have returned more than large-company stocks (although continued inquiry has added an important footnote to this finding).
- The value premium – Value company stocks have returned more than growth company stocks. Value companies are those that appear to be under- or more fairly valued by the market, relative to growth companies; they exhibit lower ratios between their stock price vs. their various business metrics such as book value, earnings, and cash flow.
What does this mean to you as an investor? It suggests financial analysts can take any two investment portfolios and compare their long-term performance using just these three factors. With more than 90% accuracy, the analysis should explain why one portfolio returned, say, 10% annualized over 20 years, while the other one only returned 5%.
To put it another way, the Fama/French three-factor model showed us that, costs aside, it barely matters whether each security in your portfolio has been hand-picked by a high-priced expert, or chosen at random by a group of dart-throwing monkeys. Almost all that matters is how you’ve allocated your holdings among (1) stocks vs. bonds, (2) small-cap vs. large-cap stocks, and (3) value vs. growth stocks. Almost any other stock-picking or market-timing efforts are far more likely to add unnecessary costs and/or unwarranted risks than to improve your returns.
This is powerful stuff to build on. In 2014, Fama and French published a five-factor asset pricing model, which now explains nearly 100% of the cross-section of expected returns. Whether returns among different portfolio builds can be explained by three or a few more factors…
If your investment portfolio were a house, your particular allocation to value stocks is an essential, load-bearing wall. It should not be abandoned lightly.
Next up, we’ll help you put a 10-year underperformance for any given stock market factor – including value stocks – into appropriate, evidence-based context.