- Cliff Asness, John Liew, Lasse Heje Pedersen, and Ashwin Thapar
- Journal of Portfolio Management
- A version of this paper can be found here
- Want to read our summaries of academic finance papers? Check out our Academic Research Insight category
What are the research questions?
Okay, we can’t keep it a secret, we are fans of value investing 1 So when Cliff Asness and his team at AQR write about value, we get excited. The analysis reported in this research confirms the relationship between static value strategies and future returns while incorporating the notion that the size of the value spread influences the size of the future value return. (you can use our free tool to review value spreads).
Using a creative approach to identify the numbers of deep value opportunities across industry subsets, countries, and asset classes, sufficient to supply statistical power, the following questions (among others) are addressed.
- What is deep value?
- Of the various theories prevalent in the literature, which one best explains the value effect?
- Is there a relationship between the size of value spreads and future returns?
- If value strategies produce higher than normal future returns during deep value episodes, can investors exploit those returns without the benefit of 20/20 hindsight?
What are the Academic Insights?
- YES. Deep value refers to the condition where “cheap stocks are especially cheap relative to expensive ones”. A deep value episode is defined as a period of time when the value spread, using any “value” metric (for example using book-to-price for equities), is larger than it’s historical 80th percentile. Deep value periods cluster in time around extreme market events such as: the internet bubble of 2000; the financial crisis of 2008; Volcker’s tenure in the early ‘80s; the invasion of Iraq in the early 90’s; the European crisis of 2012 and various other periods of bubbles or crisis. They are also correlated across asset classes.
- The authors consider four completing theories to explain the behavior of deep value securities: rational/risk theories; simple noise in prices; investor overreaction to changes in fundamentals; and investor overextrapolation of past price patterns. The authors conclude, with evidence, that the best explanation of the value premium is consistent with behavioral theories. Investors overextrapolate the history of past returns for value stocks, too far into the future. Although prices of deep value stocks do follow a deterioration in fundamentals, the degree of market reaction is not fully justified by the fundamental decline. The ability of market participants to exploit the deep value anomaly is limited by high trading costs and the degree of active risk necessary to arbitrage the anomalous performance.
- YES. There is strong evidence that changes in current deep value spreads predict the excess returns to value over the future 12-month period while controlling for standard measures of momentum and standard measures of value. Security selection and asset allocation strategies were analyzed across global asset classes (equity, fixed income, and currencies) and across geographic regions (US, Japan, Europe, and UK). The adjacent future 12-month value return was regressed on value spreads at the beginning of each observation period. The regression coefficients on the value spread were positive and significant at the 1% level. I found the results presented in Exhibit 3 below particularly persuasive. On the right-hand side of the exhibit note the behavior of ranked quintiles of value portfolios/strategies observed both before and after the periods where various sizes of value spreads occurred. That occurrence or “event” is denoted “0” on the horizontal axis. Returns are arrayed on the basis of the size of the spread ranging from deep (crossover into the 80%) to the narrowest spread. Returns for the deepest value conditions were strongest negative before the event and the strongest positive after the event. Returns for the narrowest value spread were very similar both pre- and post- event, with everything else lining up nicely in-between. Perusing this pattern one may observe a clear linear relationship between the strata of the value spread and the pre and post event returns. A comparison of these result to the standard value-growth analysis presented on the left-hand side of the exhibit shows how much of the value story we have been missing.
- YES. Out-of-sample tests of a parallel trading strategy conducted consistent with the in-sample parameters exhibited comparable success. Overall, the deep value strategy returned an alpha of 6.4% (1% level of significance) combined across all markets and securities. The out-of-sample abnormal returns were observed after controlling for traditional, static factors of value and momentum.
Why does it matter?
There are at least 2 takeaways from this research:
- First, a test of the competing theories that explain the value premium. Is value a simple risk premium or is it a result of behavioral miscalculations on the part of investors? The authors come down on the side of behavioral theories of investor overextrapolation of past history. Investor expectations of future growth for value stocks is overly pessimistic resulting in a persistent and exploitable pricing anomaly. The overextrapolation effect is the feature that distinguishes the behavioral theory from other more traditional value explanations.
- Second, a comparison of the patterns of the “event” returns, especially the deep value event returns, presented in Exhibit 3 to the standard presentation of value-growth returns presented on the left-hand side of Exhibit 3 shows how much of the value story we have been missing.
The most important chart from the paper
The authors define deep value as episodes in which the valuation spread between cheap and expensive securities is especially wide relative to its history. Examining global individual equities, equity index futures, currencies, and global bonds, the authors find that deep value is (1) highly compensated; (2) related to worsening fundamentals; (3) associated with higher risk but not fully explained by known risk factors; and (4) characterized by selling pressure related to overextrapolation of past returns and, although arbitrageurs take the other side, they face elevated trading costs and risk. These findings support a theory of return extrapolation driving the value risk premium over other behavioral and rational explanations.
- the past 10-year relative performance record certainly has us questioning this conviction. lol ↩