Improving the difficulty of value investing


Ted Theodore first wrote about price versus momentum stocks in 1984, but almost 40 years later, there is still no real sense of what strategy investors or academics are running.

This is not due to lack of research. Thousands of papers have examined equity factors across markets and asset classes, and some have analyzed strategies over more than 200 years.

Part of the problem is that performance drivers have been identified but lack widespread acceptance from practitioners. It’s understandable. If the strategy returns what is clear, fund managers will leave the job when the environment becomes unfavorable to their investment style. It is better for them to be publicly ambiguous about performance drivers, as this helps them maintain their asset management (AUM).

A second problem is that performance drivers are never crystal clear. Meaning is not a solid science with immutable, gravity-like laws. Markets are constantly changing and historical performance and trends are not entirely replicable. So when it comes to performance drivers, money practitioners must live with relatively low quality evidence.

There are four criteria in our framework for determining performance drivers:

  1. It should have an economic basis.
  2. It should work on average, but not all the time.
  3. It should be feasible.
  4. It should be retained when examined between time, market and asset class.

So what is the value factor performance driver? On what evidence do we base our decision?

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What is the value factor?

The value factor creates a positive return when cheap stocks outperform the expensive ones. So when is it?

Cheap companies tend to be troublesome companies. Otherwise, they will not trade at low valuations. Their problems can be temporary or structural: being part of an industry in the event of an overloaded balance sheet or collapse, for example. Either way, investors will find it uncomfortable to hold these stocks as the corresponding news flow and broker ratings will go down.

This means that investors will take the risk of buying companies in question when they are more confident about the economy and the stock market. When the economy goes into recession, investors prefer companies with quality or growth characteristics. Put another way: the sense of risk is the primary performance driver of the value factor.

There are many variables to measure the sense of risk. We focus on three factors: stock market volatility, stock market slant and yield curvature.

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Value factor and volatility of available stock market

We are Kenneth R. We have created a value factor from the cheapest and most expensive 10% stock on the US stock market as measured by the price-to-book ratio using data from the French Data Library. We then calculate the Z-score of stock market volatility using a three-month lookback.

1 Positive returns of most value factors from 1922 to 2020 can be attributed to the reduction of volatility. This relationship is not perfect, however: between 1931 and 1943, the price factor return decreased amid increasing volatility. But since then, the return has been consistently negative while the volatility sw has been on the rise.

Value factor and volatility of available stock markets in the United States

Chart shows the value factor and real stock market volatility in the US
Source: Kenneth R. French Data Library, Factor Research

These results provide some support for the premise that perception of risk is the key performance of the price factor: as economic volatility increases, so does stock market volatility, which usually occurs when the economy declines. Investors prefer less risky investments during this period and thus avoid cheap stocks.

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The value factor and the dilemma of the stock market

We subsequently analyzed the price factor returns in the context of stock market skew, which we calculated with a 12-month lookback. Stock market skew is a more abstract metric, but it simply means that investors can be more cautious after a stock market crash.

With its long ward upward movement and short but steep recession, the U.S. stock market is more negative than positively skewed over time. Almost all positive returns of the value factor occur during a positive slant, when there have been no serious crashes recently. Investors feel safe and are more willing to place bets on troubled companies.

Value factor and stock market skew in the United States

Chart showing the value factor and stock market skew in the United States
Source: Kenneth R. French Data Library, Factor Research

Value factor and yield curve

We calculated the yield curve as the difference between the 10-year and two-year U.S. Treasury rates. Downward-yield yield curvature is associated with a decline in economic growth and an inverse yield curvature is interpreted as a major indicator of recession. Unfortunately, the data only goes back to 1976, which limits the scope of our analysis.

We calculated the operational curve of the yield curve with a Z-score using a three-month lookback. We have seen that almost all positive returns of the value factor occur when the yield curve ward is upward, or when the economic situation is more bullish.

Value factor and yield curve in the United States

Chart showing the value factor and yield curve in the United States
Source: FRED, Kenneth R. French Data Library, Factor Research

Adjustment of metrics for factor risk management

Based on these results, investors may consider applying these metrics to the time value factor. We suggest taking it from the point of view of return. That is, we suggest paying attention to avoid significant drawdowns when the market environment is more negative for owning cheap stock.

Our multi-metric risk management framework is allocated only for the value factor when the combination of stock market volatility, market slant and yield curve was optimal. Specifically, we have modeled three scenarios in which one, two, or three signals are required for a factor assignment. Without the necessary signal, zero-interest is held instead of cash.

In terms of the range of our yield curve, the three positive signals that represent the market environment are market volatility, positive market slant and upward yield curve since 1976.

Our searches for a multi-metric framework are quite simple: the more filters, the more consistent the return but the less the exposure to the factor.

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At least one positive signal generated return is required which is comparable to the buy-and-hold value factor. However, with two or even three signals, the return was much more consistent with a significantly reduced drawdown. Overall income was lower than the value figure due to both high cash allocation and limited yield curve data.

Multi-Metric Risk Management Framework for Value Factor

Chart showing Multi-Metric Risk Management Framework for Value Factor
Source: FRED, Kenneth R. French Data Library, Factor Research

We also evaluated the performance of the value factor if the signal is negative. It can be used to minimize potential by making expensive purchases and selling cheap stock.

The one-signal requirement creates performance consistent with the buy-and-hold value factor. Two or three signals, on the other hand, have suffered a series of losses, representing the increasing volatility of a market environment, the negative skew of the market and the downward yield curve.

Multi-Metric Risk Management Framework for Value Factor: A Brief Signal

Chart showing Multi-Metric Risk Management Framework for Value Factor: Short Signals
Sources: FRED, Kenneth R. French Data Library, FactorResearch

As everyone has said, this analysis is far from perfect. We did not thoroughly examine the structure for visibility. We can use price-to-earnings instead of price-to-book for stock selection, change lookback periods, include transaction costs, apply international market and other asset class structures, and so on.

But we have used common risk-measurement variables and publicly available data, made some assumptions and applied our method to more than 90 years of financial history. This provides some relief in the significance of this result.

An obviously flawed assumption is that trading signals are applied to us on the same day. This is impossible to implement because variables and changes in the stock market occur simultaneously.

Same-Day vs. Next-Day Trading: CAGR, 1-2–2020

The chart shows same day vs. next day trading: CAGRs, 1926–2020
Source: Kenneth R. French Data Library, Factor Research

To make the signals more realistic, we analyzed what would happen if businesses were conducted the next day. This leads to a significant reduction in CAGR for the structure required for one or two positive signals, but not for three positive signals.

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More thoughts

Understanding the key value factor driving performance is extremely helpful, but implementing a framework around those drivers is challenging. It will work on average, but not consistently.

And the more investors filter around the risk sentiment metrics, the less the actual allocation of the factor and the more often cash is kept. Investors do not like to be out of the market, especially when the value factor is performing well.

It is good to know how to improve the difficulties of making returns with cheap stock, but it also makes it easier to invest in value.

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All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed must not reflect the views of the CFA Institute or the author’s employer.

Photo Credit: © Getty Images / Monticello

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Nicholas Robben

Nicholas Robben is managing director of Factor Research, which provides quantitative solutions for factor investing. Previously he founded Jacada Capital, a quantitative investment manager that focused on equity market neutral strategies. Previously, Rabener focused on real estate across the property class at GIC (Singapore Investment Corporation Government). He started working for Citigroup at Investment Banks in London and New York. Rabner holds an MS in Management from the HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance sports (100km ultramarathon, Mont Blanc, Mount Kilimanjaro).

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