Great Minds Agree to Disagree on the Source of the Value Investing Premium

Active investing sounds so easy. But we all know it is extremely difficult. Ask any deep value investor how they have felt over the past few years (although, they are feeling a lot better recently).

Certainly, any credible active investor should be able to answer 2 questions: 1) What is the source of their excess returns, or “active premium?” and 2) why is the premium is sustainable in the future?

These questions are non-trivial and academics have waged intellectual wars over these questions. The disagreements run deep among the greatest minds in finance.

Value Investing: The Greatest Academic Debate of All Time

In order to illustrate such a disagreement, we will examine how Eugene Fama, the father of market efficiency, thinks about the “value versus growth” debate, which will be familiar to our readers.

To keep things simple and in line with academic research practices, as per academic research convention, we consider value investing to be approximated roughly by the practice of purchasing portfolios of firms with low prices to some fundamental price metric (e.g., a high book-to-market or B/M ratio). Growth investing is the opposite approach—purchase firms with high prices relative to fundamentals, with the expectation that fundamentals will grow rapidly. Using Ken French’s data,¹⁴ we examine the returns from January 1, 1927, to December 31, 2014, for a value portfolio (high B/M decile, value-weighted returns), a growth portfolio (low B/M decile, value-weighted returns), and the S&P 500 total return index. By value-weight, we mean that each stock is given its weight in the portfolio, depending on the size of the firm. Results are shown in Table 1. All returns are total returns and include the reinvestment of distributions (e.g., dividends). Results are gross of fees.

Table 1: Value versus Growth (1927 to 2014)

The historical evidence is clear: value stocks from 1927 to 2014 have outperformed growth stocks—by a wide margin. The portfolio of value stocks earns a compound annual growth rate of 12.41 percent per year, whereas, the growth stock portfolio earns 8.70 percent per year, representing an approximately 4 percent annual spread in performance. This historical spread in returns, which has been repeatedly and consistently observed over time, has been labeled the value anomaly by academic researchers.

As discussed earlier, academics tend to argue about such anomalies, and the reasons why a spread like this might be so large.

In the case of the value anomaly, the disagreement is simple: Does value investing earn higher returns because value stocks are simply more risky or because they are mispriced?

We have our own recent entry in this debate with our new research paper on enterprise multiples, but we are pipsqueaks compared to intellectual kingpins like Andrei Shleifer and Eugene Fama.

Enter the Intellectual Value Investing Heavyweights: Eugene Fama vs. Andrei Shleifer

The risk vs. mispricing debate is best captured by a 2008 interview with Eugene Fama where he describes a personal conversation he had with Andrei Shleifer over a glass of wine. Fama highlights that Andrei thinks the value premium is due to mispricing, whereas Fama attributes the value premium to higher risk.

Here is a link to the interview, and we have provided a transcript that highlights the risk/mispricing debate discussed above:
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EUGENE FAMA:  …Ken and I wrote this paper about the cross-section of expected stock returns which basically said if you look at all the variables people have looked at, two seem to do pretty well, market-cap and book to market ratio.  Book to market ratio is just a price ratio, and lots of price ratios work pretty well…Up until that point there had been a lot of studies that said the CAPM doesn’t work for this reason, or the CAPM doesn’t work for this different reason.  We just put it all together and said, “It doesn’t seem to work at all.”  (LAUGHTER)…Then we said, ok, you can tell rational stories for that.  Or you can tell irrational stories…

RICHARD ROLL:  What is the rational story, and what is the irrational story.

EUGENE FAMA: …The rational story is that the size premium and the value premium are compensation for risks associated with those stocks, whereas the behavioral story says the premiums are just the result of mispricing.

RICHARD ROLL: …why are value stocks more risky than growth stocks?

EUGENE FAMA:  …because value stocks tend to be relatively distressed relative to growth stocks.

RICHARD ROLL:  They’re fallen angels?

EUGENE FAMA:  They are.  Lots of them are fallen angels. So it’s reasonable to think they have higher costs of capital than growth stocks.  Whereas the CAPM says the opposite. Basically growth stocks have higher betas than value stocks.  So that model is saying growth stocks have higher costs of capital.

RICHARD ROLL:  Normally you think of a high beta stock like a growth stock.  The CAPM says it’s more risky.  This is contrary to that.

EUGENE FAMA:  Right, but to make full sense of that, you have to go back to something like…the APT (Arbitrage Pricing Theory) model…something where there are multiple factors.  Then you have to tell some kind of story about why there are differential risk premiums per unit of variance.  That is the essence of the multi-factor model.

RICHARD ROLL:  If you take the APT model, those things should be related to the covariance matrix of returns. They couldn’t be risk premiums if they weren’t related.  So are they?

EUGENE FAMA:  They are indeed. If you go back and look at the original paper by Lakonishok, Shleifer and Vishny, it basically says that the value premium is an arbitrage opportunity [our take].  You can go long value stocks and short growth stocks and have a portfolio that has zero variance, essentially.  I remember going to dinner with Andre and after a bottle or so of wine, I pulled out some output, and said,

Here’s what happens if you actually do this.  The variance that you get is on the order of the variance of the market. It doesn’t look like an arbitrage opportunity to me.

Andrei said,

“Well ok, maybe it looks like a risk factor, but the risk premium is irrational.”

Now at that point you’re in a box.  You can’t tell the difference between the rational story and the irrational story.  So that’s basically where it stands today.  I think everybody agrees that the difference between value and growth returns has a big variance associated with it.  They disagree about the explanation.

RICHARD ROLL:  Whether it’s a risk premium or a market opportunity?  But as you have said, if you take a hedge portfolio, that’s certainly not risk free.

EUGENE FAMA:  No, far from it.
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Bottom line: Great minds can disagree on the explanation, but nobody can dispute the empirical fact that value stocks have outperformed growth stocks by a wide margin over time. One would also be remiss in suggesting that exploiting the edge in value investing is easy — it’s highly volatile and needs to be pooled in a broader portfolio, ideally alongside momentum.