In Practice Summary: Value Investing — Do Quant Strategies Measure Up?

Is your value fund really a value fund?

The ugly truth is that many value funds apply dime-a-dozen strategies built on formulaic accounting ratios. Investors are better off looking for managers who deploy more comprehensive analysis to determine the intrinsic value of the underlying securities.

This edition of In Practice summarizes the new research, “Facts about Formulaic Value Investing,” published in CFA Institute Financial Analysts Journal^®. The study’s authors, led by U-Wen Kok, CFA, suggest there is little compelling evidence to indicate conventional value approaches deliver superior investment performance for US equities.

What’s the investment issue?

Value investing is one of the most popular and enduring investment styles. But do strategies that rely merely on formulaic ratios, such as book-to-market, yield the returns investors expect?

Security Analysis, the classic 1934 value investing text by Benjamin Graham and David Dodd, advocated buying stocks trading at a significant discount to intrinsic value but specifically avoided a formula-focused approach. Graham and Dodd’s strategy is still used by many investors, but with the proliferation of computer technology, the term “value investing” is now often applied to mechanical investment strategies derived from simple ratios of accounting numbers to stock prices. Such products have become ubiquitous. Vanguard’s Value Index Fund, for instance, manages some $44 billion in assets, while BlackRock’s iShares Russell 1000 Value ETF manages $31 billion.

The authors explore whether these formula-based methods constitute traditional value strategies and if more nuanced analyses of companies’ “intrinsic value” are better at identifying temporarily underpriced securities.

How do the authors tackle the issue?

The researchers re-examine the performance of the book-to-market ratio — based on the Fama–French value factor by applying more detailed and granular analysis to the same data. The Fama and French findings, published in 1998 in the Journal of Finance, are highly regarded by some asset management practitioners. To better understand the source of the returns to the Fama–French value factor, the authors report the returns by company size.

They focus their analysis on two common fundamental-to-price ratios — trailing earnings and forward earnings — as well as book value. The sample includes all companies in the Russell 3000 Index from 2002 to 2014.

The authors also examine the correlation between fundamental-to-price ratios and subsequent changes in fundamentals to test whether a strategy along the lines of Graham and Dodd’s original thesis could outperform its more formulaic counterparts.

What are the findings?

There is no compelling evidence that buying US equities that are underpriced based on simple fundamental-to-price ratios yields better performance than investing in broad market indexes.

There is some evidence of a premium for the book-to-market ratio from 1963 to 1981, although not for large-cap stocks. Outside this time frame, however, the premium is weak to nonexistent, with no proof of a significant value effect from 1926 to 1962. There is a premium from 1982 to 2015, but it is primarily attributable to small-cap stocks.

In addition, small-cap stocks that appear expensive based on fundamental ratios have underperformed. Shorting these stocks to take advantage of this finding is not easy: They are relatively capacity constrained, illiquid, and costly to borrow.

The scant evidence of a value premium, at least during these particular periods, suggests that using simple ratios of accounting fundamentals to prices doesn’t identify underpriced securities so much as those with temporarily inflated accounting numbers. The authors found that:

• The book-to-market ratio tends to identify equities with overstated book values that are subsequently written down.
• The trailing earnings-to-price ratio tends to find securities with temporarily high earnings that subsequently decline.
• The forward earnings-to-price ratio tends to identify securities for which sell-side analysts have optimistic forecasts of future earnings.

A sophisticated fundamental analysis could significantly increase investor returns relative to formulaic strategies. Although the simple book-to-market formula yields an insignificant annualized return of 4.1%, adjusting for expected changes in book values results in a return of 17.8%. Of course, this suggests that analysts can anticipate changes in book value. Such a conclusion is open to question.

What are the implications for investors and investment managers?

Ratio-based quantitative investment methods are not good substitutes for value investing strategies that apply additional screening or more comprehensive approaches to identifying underpriced securities.

The failure of such methods represents an opportunity for skilled managers. The authors believe managers can enhance simplified quantitative strategies with the fundamental security analysis proposed by Graham and Dodd. They show conventional value investing methods identify stocks with inflated accounting numbers that subsequently mean revert, which may be useful information for analysts.

Their research also serves as a reminder of the potential dangers of backtested performance. After all, more than 80 years ago, Graham and Dodd argued that trading strategies built on simple valuation ratios were unlikely to generate superior performance. With the advent of computers and financial databases, that lesson seems to have been unlearned. Thousands of mechanical strategies have been backtested, and it is not surprising that some have worked in some markets over some time periods.

The authors caution against using evidence from data mining to conclude that formulaic approaches can deliver healthy outperformance in the future.

This article is an In Practice summary of “Facts about Formulaic Value Investing” by U-Wen Kok, CFA, Jason Ribando, CFA, and Richard Sloan from the CFA Institute Financial Analysts Journal^®.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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