Three main points emerge from their study which covers the period from 1963 through 2015:
For a given E/P [earnings-to-price], a high B/P [book value-to-price] indicates a higher likelihood that growth will not be realized. While a high B/P stock might look cheap, that could be a trap.
- E/P and B/P multiples should be employed together as they convey risk and the expected return for that risk.
- When applied jointly with E/P, high B/P (a value stock) indicates higher future earnings growth. For
manythis will seem surprising as the standard labeling implies that it is low B/P that buys growth, not value.
- The higher growth associated with high B/P is risky—high B/P stocks are subject to more extreme shocks to growth.
Value Connects to Profitability and RiskBy walking through the basic accounting principles, Penman and Reggiani showed why value connects to low profitability and why that connection implies risky outcomes. Their explanations are also consistent with the findings from prior research. For example:
- Nai-fu Chen and Feng Zhang, authors of the study “Risk and Return of Value Stocks” found that value stocks have a high standard deviation of earnings.
- Lu Zhang, author of the study “The Value Premium.” concluded that the value premium could be explained by the asymmetric risk of value stocks. Value stocks are much riskier than growth stocks in bad economic times and only moderately less risky than growth stocks in good times.
- Ralitsa Petkova, author of the “Do the Fama-French Factors Proxy for Innovations in Predictive Variables?” found that value companies tend to be firms under distress, with high leverage and high uncertainty of cash flow.
Given E/P, B/P is Positively Related to Subsequent Earnings GrowthPenman and Reggiani next showed that for a given E/P, B/P is positively related to subsequent earnings growth. Ranking stocks first by E/P and then B/P, they created the same 25 portfolios. They then examined the mean earnings growth rates two years ahead for these portfolios. They found that E/P predicts subsequent earnings growth (higher P/E, lower E/P, predicts higher growth in earnings). However, for a given E/P, B/P is positively correlated with growth, with the difference in growth rates particularly strong for lower E/P portfolios with the higher growth expectations. For example, earnings growth was 41 percent for the low E/P, high B/P portfolio versus -12.5 percent for the high E/P, low B/P portfolio. All of the data was statistically significant with t-stats ranging from 6.5 to 2.0. By sorting stocks based on the volatility of next year’s earnings, Penman and Reggiani documented that the higher earnings growth in the low E/P, high B/P portfolio came with greater risk to those earnings. They showed that for a given E/P, B/P is positively associated with subsequent earnings growth risk. A higher B/P indicates that one is buying both riskier forward earnings and subsequent earnings growth. This was true for all levels of E/P, including high E/P (“value”) and low E/P (“growth”). It was also true for negative E/P (loss firms) that are often associated with particularly strong expensing of investment. For example, the standard deviation of one-year ahead realized earnings for the high E/P, low B/P portfolio was 4.5 percent versus 13.9 percent for the low E/P, high B/P portfolio. At the two-year horizon the figures were 14.3 percent and 26.3 percent, respectively. Connecting the variance of growth rates to that of stock returns, they found that the correlation between the standard deviation of earnings growth rates for the B/P portfolios with the standard deviation of returns in the same year as the growth realizations was 0.69. They concluded that not only does B/P indicate expected growth but also the variance around that expectation. B/P indicates whether a given E/P is one with high growth and risk or low growth and risk—B/P indicates a higher chance of a high-growth outcome but also a higher chance of growth falling in the lower tail.
Diversifiable or Systematic Risk?Under asset pricing theory, risk is priced only if it pertains to sensitivity to risk that cannot be diversified away. With that in mind, Penman and Reggiani looked to see if risk to earnings is associated with shocks to market-wide earnings. Separating years in which the market-wide earnings yield was up from the previous year (up-markets) from years when it was down (down-markets), they found that high B/P stocks have higher up-market betas, delivering higher earnings in good times, but also have higher down-market betas, a trap that is compensated with higher upside potential. Correspondingly, low B/P portfolios have considerably lower betas in down-markets, but their upside beta is also lower. For example, the high E/P, low B/P portfolio has a conditional up-market beta of 1.24 versus 2.41 for the low E/P, High B/P portfolio. The down-market betas were 0.70 for the high E/P, low B/P portfolio and 5.02 for the low E/P, high B/P portfolio. They concluded that the variation in earnings outcomes across B/P portfolios is due, in part, to economy-wide shocks—systematic risks that cannot be diversified away, and that the spread in portfolio returns can be interpreted as compensation for bearing risk. They do also note that the abnormal (alpha) returns could be a result of the market mispricing earnings growth. In support of the risk explanation they cite the results from 2008 when growth expectations took a large hit, and the spreads were negative for all E/P portfolios: for a given E/P, high B/P (and low ROE) earned lower returns than low B/P (high ROE).
Firm Size and Value vs. Growth InvestingAs noted earlier, the spreads for value-weighted returns are lower than those for equally-weighted returns, suggesting that the phenomena is stronger in small firms than large firms—which is logical as small firms are more likely to be growth prospects, but with growth that is more at risk. The flip side is that large firms are those with lower growth prospects, but growth is less risky. That explains why the value premium for B/P has been much greater in small stocks than in large stocks—B/P plays no role (incremental to E/P) when there is little expected growth at risk. In addition, Penman and Reggiani found that for a given E/P, the return spread between high and low B/P portfolios is decreasing in firm size and that the B/P return spread is negligible for large firms in all E/P portfolios. They also found that in the (E/P, B/P) pairs reported for the quintiles, E/P is increasing in firm size, but B/P is decreasing. Penman and Reggiani examined another measure, the earnings grow beta, which measures the sensitivity of earning growth to variation of market-wide growth rates. They found that these betas are also decreasing in firm size. Summarizing, when buying “value” firms with low multiples, investors may be taking on risk of buying earnings growth that may not materialize. A relatively high E/P stock, a so-called “value” stock, is typically viewed as one with low growth expectations. However, it could be one with high growth expectations with the growth being risky. Penman and Reggiani provide support for a risk-based explanation for the value premium. However, as I noted, there is a great debate, with literature also providing behavioral explanations.
The Behavioral Side of the TaleTo take a look at the research supporting a behavioral explanation we can examine the findings of the study “Why do Enterprise Multiples Predict Expected Stock Returns?” The authors, Steven S. Crawford, Wesley Gray, and Jack Vogel, examined the returns to the enterprise factor over the period from 1972 through 2015. The enterprise multiple is calculated as enterprise value (EV = equity + debt + preferred stock – cash) divided by earnings before interest taxes depreciation and amortization (EBITDA = operating income before depreciation and amortization). They found that consistent with the existing literature, there has been a strong enterprise multiple (EM) premium in the U.S.—low EM firms significantly outperform high EM firms.
- Among firms where the expectations implied by their current value/glamour classification were consistent with the strength of their fundamentals, the value/glamour effect in realized returns is statistically and economically indistinguishable from zero, arguing against a risk-based explanation.
- The returns to traditional value/glamour strategies are concentrated among those firms where the expectations implied by their current value/glamour classification are incongruent
ex antewith the strength of their fundamentals.
- Returns to this “incongruent value/glamour strategy” are robust and significantly larger than the average return generated by a traditional value/glamour strategy.
- Net Stock Issues: Net stock issuance and stock returns are negatively correlated. It has been shown that smart company management issues
shareswhen sentiment-driven traders push prices to overvalued levels.
- Composite Equity Issues: Issuers underperform non-issuers with “composite equity issuance,” defined as the growth in a firm’s total market value of equity minus the stock’s rate of return. It’s computed by subtracting the 12-month cumulative stock return from the 12-month growth in equity market capitalization.
- Accruals: Firms with high accruals earn abnormally lower average returns than firms with low accruals.
- Net Operating Assets: The difference on a firm’s balance sheet between all operating assets and all operating liabilities, scaled by total assets, is a strong negative predictor of long-run stock returns.
- Asset Growth: Companies that grow their total assets more earn lower subsequent returns.
- Investment-to-Assets: Higher past corporate investment predicts abnormally lower future returns.
- Distress: Firms with high failure probabilities have lower subsequent returns.
- Momentum: High (low) recent past returns forecast high (low) future returns.
- Gross Profitability: More profitable firms have higher expected returns than less profitable firms.
- Return on Assets: More profitable firms have higher expected returns than less profitable firms.
- Ohlson O-Score: Stocks with a high risk of bankruptcy have lower returns than stocks with a low risk of bankruptcy.
- Portfolios with high investor expectation errors earn higher returns than portfolios with low investor expectation errors.
- Consistent with the hypothesis that the EM effect is likely explained by mispricing, in the low-mispricing portfolios, the reported four-factor (beta, size, value
andmomentum) alpha estimates are not statistically different from zero, while the four-factor alpha estimates for the high-mispricing portfolios are positive and significant at the 5 percent level in every instance.
- Examining earnings announcement returns, forecast errors and forecast revisions, evidence supported the notion that the EM effect is driven, at least in part, by mispricing associated with predictable investor expectation errors. For example, the average announcement return for the value portfolio with high expectation errors (i.e., cheap, with high fundamental value) is 0.65 percent, which is larger than the -0.22 percent average announcement return for the glamour portfolio with high expectation errors (i.e., expensive, with low fundamental value). The difference in these two returns is the announcement return in the high-mispricing portfolio of 0.87 percent, which is significant at the 1 percent level. On the other hand, the returns to firms in the two portfolios with low expectation errors are similar.
- Returns to the high-mispricing EM strategy are significantly higher during periods of high investor sentiment relative to times of low investor sentiment. The same pattern doesn’t hold for the low-mispricing portfolio, providing further support to the mispricing-based hypothesis.
Crawford, Gray, and Vogel concluded:
To the extent that managing short positions is costly, these results suggest that the mispricing associated with the high-mispricing EM portfolio is difficult to profitably exploit. In addition, if costly market frictions continue to exist and investor expectation errors persist, we can expect that the EM effect may continue in the future.
The evidence supports the hypothesis that the excess returns associated with EM sorted portfolios is driven by mispricing and not increased systematic risk exposure.