There’s extensive literature documenting that value stocks (the stocks of companies with low prices relative to a valuation metric, such as earnings, book value, cash flow or sales) possess a strong, persistent and pervasive tendency to outperform growth stocks.
While there’s no debate about the existence of the value premium, there’s a major debate about the source of the return differential. Some argue that returns reflect compensation for risk; others argue for mispricing.
The mispricing explanation for the value premium is that investors are systematically too optimistic in their expectations for the performance of growth companies, and too pessimistic in their expectations of value companies. Ultimately, prices correct when these expectations aren’t met.
Value And Mispricing
Joseph Piotroski and Eric So, authors of the study “Identifying Expectation Errors in Value/Glamour Strategies: A Fundamental Analysis Approach,” which was published in the September 2012 issue of The Review of Financial Studies, tested the mispricing hypothesis by identifying potential ex-ante biases and comparing the expectations implied by pricing multiples against the strength of firms’ fundamentals. Value strategies would be successful if prices don’t accurately reflect the future cash flow implications of historical information in a timely manner, resulting in equity prices that temporarily drift away from their fundamental value.
Piotroski and So classified and allocated firm-year observations into value and glamour (growth) portfolios on the basis of each firm’s book-to-market ratio. Because a firm’s book-to-market ratio reflects the market’s expectations about future performance, sorting by this metric will group firms on the basis of future performance expectations embedded in prices. Thus, book-to-market ratios serve as an empirical proxy for the relative strength of the market’s expectations about future firm performance.
The authors classified the strength of a firm’s recent financial performance trends using the aggregate statistic F-Score, which is based on nine financial signals designed to measure three different dimensions of a company’s financial condition: profitability, change in financial leverage/liquidity (capital structure) and change in operational efficiency.
Firms with the poorest signals have the strongest deterioration in fundamentals and are classified as low F-Score firms. Firms that receive the highest score have the strongest improvement in fundamentals and are classified as high F-Score firms.
Prior research shows that F-Score is positively correlated with future earnings growth and future profitability levels. Low F-Score firms experience continued deterioration in future profitability, and high F-Score firms experience overall improvement in profitability.
Study Results
Following is a summary of the authors’ findings, which cover the period 1972 through 2010:
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.
The returns to traditional value/glamour strategies are concentrated among firms where the expectations implied by their current value/glamour classification are ex-ante incongruent with 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.
In the academic literature, the explanation for the mispricing is that behavioral errors—such as optimism, anchoring and confirmation biases—cause investors to underweight or ignore contrarian information.
The authors write: “For example, investors in glamour stocks are likely to under-react to information that contradict their beliefs about firms’ growth prospects or reflect the effects of mean reversion in performance. Similarly, value stocks, being inherently more distressed than glamour stocks, tend to be neglected by investors; as a result, performance expectations for value firms may be too pessimistic and reflect improvements in fundamentals too slowly.”
Piotroski and So’s findings were consistent with the mispricing explanation. They concluded that firms with low book-to-market ratios and low F-Scores (weak fundamentals) were persistently overvalued, and firms with high book-to-market ratios and high F-Scores (strong fundamentals) were persistently undervalued. It was in these subsets that the pricing errors were strongest.
The authors also observed that while both the traditional value/glamour strategy (which relies solely on book-to-market rankings) and the incongruent value/glamour strategy produce consistently positive annual returns, the frequency of these positive returns was higher for the incongruent value/glamour strategy. It generated positive returns in 35 out of 39 years over the sample period (versus 27 out of 39 years for the traditional value/glamour strategy).
They also found that annual returns to the incongruent value/glamour strategy were larger than returns to the traditional value/glamour strategy in all but six years, with an average annual portfolio return of 20.8% versus 10.5% for the traditional value/glamour strategy.
The evidence from this study contributed to the growing body of literature demonstrating that, at the very least, the value premium has been too large to be explained solely by a risk story. In other words, it’s an anomaly.
Digging Into The F-Score Anomaly
The success of the Piotroski high F-Score led to its popularity. F-Score data is readily available on several websites (the American Association of Individual Investors, MeetInvest and ValueSignals, for instance). In addition, since May 2002, the American Association of Individual Investors, using its Stock Investor Pro software to run a live version of Piotroski’s screen on paper with regular updates every month, has shown raw returns of 23.7% from January 2005 to April 2015 for the U.S. stock market. However, the impact of market frictions, such as trading costs, liquidity constraints and microstructure effects, weren’t considered. The results are, therefore, only theoretical.
Christopher Krauss, Tom Krüger and Daniel Beerstecher, who authored an October 2015 paper titled “The Piotroski F-Score: A Fundamental Value Strategy Revisited from an Investor’s Perspective,” sought to determine whether the F-score anomaly could be exploited when real-world market frictions and exposure to common factors were considered. They ask: Does the Piotroski high F-Score actually achieve statistically significant, risk-adjusted returns?
The authors tested weekly and monthly rebalancing strategies and both long-only and long-short strategies. Piotroski had suggested shorting low F-Score firms. But the feasibility of strategies addressing capital market anomalies is often more aggressively challenged on the short side due to high costs. To address this issue, the authors chose to create a dollar-neutral portfolio by going short the same dollar amount in the S&P 500 as they were invested in high-F-Score firms.
This strategy is not necessarily market neutral, since the high F-Score firms in the high book-to-market universe may well exhibit an aggregate beta unequal to one. Also, the exposure to small companies and the high book-to-market universe is not hedged. On the other hand, this long-short strategy can easily be implemented at a low cost and is suitable from a practitioner’s perspective.
In terms of market frictions, the authors assumed commissions of 0.1% and round-trip trading costs of 0.5%. They also incorporated liquidity constraints, excluding stocks with a daily trading volume below a certain liquidity threshold. And finally, they incorporated a one-day waiting rule to consider potential microstructure effects, such as the bid/ask bounce. The result is that they delay transactions by one day after the signal.
Research Findings
Following is a summary of their findings:
The value-weighted (equal-weighted) monthly long-only Piotroski screen showed a raw return of 2.42 (2.71)% per month prior to trading costs, with a t-stat of 2.5. Thus, it was statistically significant at the 5% confidence level.
The value-weighted (equal-weighted) long-short monthly strategy produced a raw return of 1.84 (2.01)% per month, with a t-stat of 2.4.
Relative to benchmarks of the S&P 500 and four other indexes—the S&P MidCap 400, the S&P MidCap 400/Citigroup Value, the S&P SmallCap 600 and the S&P SmallCap 600/Citigroup Value—the F-Score strategies also produced superior risk-adjusted returns in measures such as their Sharpe ratios, value and risk, and drawdowns.
Relative to the Fama-French three-factor (beta, size and value), four-factor (adding momentum) and five-factor (adding profitability and investment) models, only a small portion of the returns can be attributed to the different risk factors.
Introducing liquidity constraints (minimum daily volume of $1 million) and introducing the one-day trading lag causes returns to decline from 2.71% per month (the original long-only strategy) to 1.1% per month.
Subtract the estimated transaction costs of 0.007 (0.7%) per month and the strategy no longer seems attractive. In addition, the average number of positions per month decreases from approximately nine holdings to less than three, which certainly is not possible for institutions. Adding a minimum liquidity requirement of $100,000 on the day of the signal leads to monthly raw returns of merely 0.15%, close to the average risk-free rate of 0.11% over the period of study.
When testing the strategy on a weekly rebalancing basis, the authors found that the strategy’s results were even more impressive in raw terms, as returns were greater than 4% per month and t-stats were also higher (larger than 5).
However, once again, liquidity constraints and trading costs make these strategies impractical in the real world, at least for any institutional investor. For example, weekly transaction costs of 0.70% consume the lion’s share of the 1.09% weekly return. In addition, constraining the minimum volume to $30,000 per day renders the strategy virtually unprofitable. What’s more, it’s important to note, the average number of holdings declines from 9.4 to 2.6.
The authors noted that “acting faster upon the new arrival of information leads to much higher annualized returns. However, the higher rebalancing frequency is detrimental to the returns due to elevated transaction costs. Liquidity constraints that render the strategy feasible also render it unprofitable.”
Friction Eats Anomaly Benefits
The authors concluded their results indicate that while the monthly (although not the weekly) strategy might be implementable for a very small individual investor, “any larger scale investor stands no chance of capturing the returns reported by the AAII. Overall, the value of the investment strategy seems to be mainly theoretical.”
Krauss, Krüger, and Beerstecher’s study shows how high frictions can allow anomalies to persist. The study also demonstrates how difficult it is to exploit some anomalies once real-world trading costs and liquidity constraints are imposed.
A fitting conclusion is the following from financial economist and money manager Richard Roll, who, in 2000, was responding to criticisms of the efficient market hypothesis: “I have personally tried to invest money, my client’s and my own, in every single anomaly and predictive result that academics have dreamed up. And I have yet to make a nickel on any of these supposed market inefficiencies. An inefficiency ought to be an exploitable opportunity. If there’s nothing investors can exploit in a systematic way, time in and time out, then it’s very hard to say that information is not being properly incorporated into stock prices. Real money investment strategies don’t produce the results that academic papers say they should.”
This commentary originally appeared July 6 on ETF.com
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© 2016, The BAM ALLIANCE
Charleston, South Carolina. According to Travel + Leisure magazine, “Charleston is a remarkably dynamic place, so it’s no surprise that it has achieved its highest ranking ever in our survey as the year’s best city in the world.”
It’s the first time a U.S. city has received the top honor, but Charleston ranked No. 2 last year and has been ranked the No. 1 city in the U.S. and Canada for four years running. As scored by Travel + Leisurereaders, Charleston received its top-ranked status based on six categories: sights/landmarks, culture/arts, restaurants/food, people/friendliness, shopping and value.
But please allow me to give you the top three reasons why my family moved to Charleston two years ago, and the reason we’ll stay (and invite you to join us).
First, a little background. When people ask me where I’m from, the answer is no different today than it has been all my life: Baltimore. I’m a Baltimorean—or, as we lovingly refer to ourselves, Baltimorons. I was born in Bal’mer and never lived outside a 30-mile radius from it for the first 38 years of my life (and that includes my college years). I so loved the place and its people—my people—that I couldn’t imagine leaving its Old Bay-scented landscape.
My beloved family and extended family, including two sets of adoring grandparents, are all in Baltimore, not to mention a lifetime of dear friends and, of course, the Orioles and the Ravens. Baltimore will always be home.
But about three years ago, my wife, Andrea, and I were on one of those peculiar outings called “Date Night,” the domain of parents with young children availing themselves of the rare adult conversation. After an apparently tall glass of red wine, my wife took a very deep breath and announced that she thought we should move. I assumed the suggestion would require replanting only an exit or two along I-695, so I nearly choked on my crab cake when I learned that my bride was lobbying for a much bigger move—to Charleston. South Carolina.
Masking my unarticulated fear of leaving all that I knew behind, I responded with a barrage of practical protestations:
“It’s a celebrated resort town. It probably costs a fortune to live there!”
But she’d done her research, and immediately pulled up several beautiful houses on her phone that we could never have afforded had they been in Baltimore. Yet, they boasted price tags far lower than the home we were currently living in.
“Then there must be bad public schools,” I next objected. “Anything we save on the house, we’ll likely have to shell out for expensive private school!”
Again, she showed me ratings for schools in the Charleston suburb of Mount Pleasant that rivaled or bested those of the excellent schools our children attended in Baltimore.
I was running out of practical excuses not to leave, but there was no chance she could muster an argument to counter the biggest reason of all—my fear of leaving everyone and everything behind. Indeed, she couldn’t do anything to change THE reason I didn’t want to leave my hometown. That change would have to happen on its own:
The Top 3 Reasons We Moved to Charleston:
3 – Lower cost of living
People don’t think of Baltimore as being an expensive city, but it is. No, it’s not as expensive as some of its Northeast rivals, D.C., Philly, New York or Boston, but relative to most of the country, it ain’t cheap. The move to Charleston enabled us to buy the nicest home we’d ever lived in for meaningfully less money. (I must disclaim, however, that as Charleston’s status as a world-class city becomes more well-known, the flood of new residents has closed the gap between Charm City and my hometown, but those from D.C., New York, Boston or Southern California would still find it a bargain.)
2 – Slower pace of life
Yes, Southern hospitality is a real thing, as Travel + Leisure found, with eight of its top 12 best U.S. cities located in the Southeast or Southwest. But Charleston and the surrounding area is also marked by the lesser-known and still elusive “Lowcountry lifestyle.” It’s better felt than explained, but this outsider notes a more deliberate (not “slower”) pace of life with a heightened appreciation for the natural beauty of the region and an emphasis on relationships. Busyness is more a sign of misplaced priorities than a badge of honor here, while a turning tide or spontaneous happy hour are entirely responsible reasons to reschedule a conference call.
1 – A family adventure
But the No. 1 reason to stay in Baltimore became the No. 1 reason to leave. Have you ever wondered what it would look like to leave everything and everyone you know and plop down in a place about which you knew nothing and no one? As I considered this notion, the prospect of moving was transformed from a fear to an attractive step of faith. I feared separating myself—and especially my children—from the relative comfort we’d found in knowing. The change came when we began to yearn for the excitement of discovering. We weren’t so much leaving Baltimore as we were going on an adventure.
The Reason We’ll Stay In Charleston:
In short, it has exceeded our high expectations. Yes, the well-preserved Colonial downtown with an outsized cultural scene nestled among three rivers, countless tidal creeks and several vibrant beach communities is likely what puts it on the world’s map. But the place is far outshined by its people—a confluence of those who exhibit Lowcountry ideals and those in search of just such substance. However, the primary reason we’ll stay has less to do with Charleston and more to do with us.
Marcel Proust said, “The voyage of discovery is not in seeking new landscapes but in having new eyes.”
It was the act of choosing to discover that has given us new eyes, even as we enjoy the discovery. As a family of four, we decided to go on an adventure, and we’re just getting started.
Wherever you are—and wherever you may go—what implications might that choice have for you, your work or your family?
This commentary originally appeared July 9 on Forbes.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2016, The BAM ALLIANCE
Bond ladders are frequently criticized in the financial media and even among some professional advisors (who, I would point out, are often able to use only bond mutual funds or ETFs). Earlier this week, we corrected some common misperceptions regarding individually tailored laddered municipal bond portfolios. Today we’ll move on to the many advantages of owning one.
The Benefits
An important benefit of owning individual bonds is that they avoid the fees investors have to pay a fund manager.
Perhaps the most important benefit of owning individual bond securities is that investors take 100% control over the credit risk and term risk of their portfolios. They also take control over the timing of cash flows into and out of such a portfolio. This is particularly important to investors relying on their fixed-income assets to provide the cash flow they need to maintain their desired lifestyle (in retirement or otherwise).
A related issue is that municipal bond funds (and corporate bond funds) typically own bonds with call risk (the issuer has the right to prepay the bond). Those bonds carry slightly higher yields to compensate investors for taking this risk.
However, not only does that feature cause investors to lose control over the maturity of their bonds, the reinvestment risk that calls create can show up at the wrong time, when stocks are doing poorly. The issuer will call in the bond and investors now have to reinvest the proceeds at lower rates. If you are going to even consider buying a bond with a call feature, require that it have at least 80% protection (meaning a bond with 10 years to maturity has at least eight years of call protection).
There’s another little-discussed benefit of owning individual securities. With a mutual fund, after a period of falling interest rates, “hot money” chasing recent performance will typically buy into the fund. The fund, therefore, must buy more bonds in a low-rate environment, thus lowering the average rate for all investors. Then, if rates begin to rise, the hot money will often leave, forcing the fund (and long-term investors in it) to suffer trading costs and capital losses that can’t be “waited out.”
On the other hand, an investor who holds individual bonds, and who is satisfied with the yield to maturity when the bond was purchased, is not subject to the same problem (that is, other investors cannot force him to sell at depressed prices).
Another advantage of owning individual municipal bonds is that in a rising-rate environment, investors have the ability to tax manage (harvest losses) at the individual security level rather than just the fund level.
Note that this option is a greater benefit with municipal bonds than it is with stocks. With stocks, when you harvest a loss, you reset the basis and eventually (unless you receive a stepped-up basis upon death) will have to pay a tax on the now-larger gain. Thus, your benefit is the time value of money. With municipal bonds, when you suffer a loss and buy a similar bond at a now-higher interest rate, you get the full value of the tax benefit because the higher interest rate you now earn is tax-free.
Another key advantage of laddered portfolios is the ability to maximize the after-tax return on municipal bonds by tailoring holdings to individual investors’ state and tax bracket.
For example, the bonds of high-tax states (such as New York and California) tend to trade at lower yields (due to demand from their residents for double tax-free interest) than bonds from no- or low-tax states (such as Florida, Nevada and Texas). Unless you’re a resident of a particular high-tax-rate state, there is no reason to own their bonds because you can earn higher after-tax returns purchasing the bonds of low-tax states.
Yet if you own a national municipal bond fund (like those from Vanguard), you are going to hold a high percentage of bonds originating from high-tax states. For example, according to its 2015 annual report, the Vanguard Intermediate-Term Tax-Exempt Fund (VWITX) had about 15% of its holdings in California bonds and about 12% in New York bonds.
Some critics of laddered bond portfolios imply that lower yields on bonds from states such as New York and California is a reflection of their lower risk. Unfortunately, that is not correct. It’s a result of their higher tax rates, which leads to more demand for them from their own residents. This should be obvious, as similarly rated bonds with the same maturity from zero-tax-rate states such as Florida, Nevada and Texas carry higher yields.
Other Advantages
Clearly, there are some diversification benefits that come with a national bond fund, but you can get more than sufficient diversification buying bonds from the lower-tax-rate states. And as I noted earlier this week, if you limit your holdings to bonds of the highest credit quality (as I would recommend), there is far less need for diversification.
Another benefit of bond ladders is that investors can take advantage of the differences in the shape of the yield curves between taxable and municipal bonds. Because the municipal bond yield curve is typically steeper than the yield curve for Treasury bonds, there are times in which even higher-tax-bracket investors can benefit from buying taxable bonds or FDIC-insured CDs for the shorter maturities in their ladder and municipals for the longer end. This has often been the case over the past five years for even some of the highest-tax-bracket investors and for maturities of up to five years.
Finally, bond funds may contain municipal bonds that generate income subject to the alternative minimum tax. Fund managers buy such bonds to boost the yield, attracting less-knowledgeable investors. These bonds can be avoided when building your own portfolio.
Summary
When it comes to investing in equities, in general, mutual funds provide a major advantage over individual securities because of the need to diversify the idiosyncratic risk of stocks. However, if investors limit their municipal bond holdings to only the highest-quality issues (the only type of bond I recommend), there’s very little need for diversification. What’s more, you’ll be able to take advantage of the times when taxable investments provide higher returns than municipal bonds.
Given the many significant benefits that individual bonds can provide, if you or your advisor has access to institutional pricing and your portfolio is in the area of $1 million or more, you should consider owning individual municipal bonds. I recommend that $1 million threshold to achieve sufficient diversification levels.
And when it comes to taxable investments, because Treasurys and FDIC-insured CDs have no credit risk, and you can buy small amounts, there simply is no need for mutual funds, except for their convenience, or inside of corporate retirement plans where CDs are not generally available.
If you are using a financial advisor who invests in bond mutual funds instead, ask her to explain why. Now that you’re educated on the issues, you are well-armed to address the canards typically raised.
This commentary originally appeared July 13 on ETF.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2016, The BAM ALLIANCE