Efficient Market Hypothesis proponents, like good lawyers, argue that there is absolutely no such thing as a permanent edge in investing and any permanent edge that does exist is riskier than the alternatives. (“Your honor, my client was never in that woman’s apartment and he was only there to return her lost kitten”). I mean, why paint yourself into a corner?
Fama and French (F&F) and almost every other speaker in the above video said that the reason that value stocks consistently outperformed “growth” (glamour) stocks was that there was some additional risk in value stocks. Unfortunately, this only seems to be F&F’s hope because they certainly do not quantify that risk in their now-legendary 1992 paper in the Journal of Finance, “A Cross Section of expected Stock Returns.” To my knowledge they were not able to quantify that risk at any point in the last eighteen years.
F&F thought that they saw some evidence of low earnings in small cap stocks and value stocks. That led them to write the following in the conclusion to “A Cross Section of expected Stock Returns:”
“The systematic patterns in fundamentals give us some hope that size and book-to-market equity proxy for risk factors…”[1]
So, to summarize F&F’s conclusion: immediately prior to a company being added to a value cohort in their study, some value stocks experienced a period of low earnings. That was all they had. I am not aware of any follow up in the last eighteen years to F&F’s hope that small stocks and value stocks proxy for risk because of low earnings or for any other reason. It seems to me that hypothesis could be tested pretty easily.
Real risk usually has little to do with a period of low earnings alone; virtually every company goes through that. But, real risk is related to high leverage, which can quickly lead to bankruptcy. What are the odds that a highly leveraged business will have a high book-to-market ratio (book value / market value)? That is, what are the odds that a highly leveraged business would finds its way into F&F’s value cohort? Considering that for a given capital structure, book value is reduced by leverage, all other things being equal, I suspect you will find few highly leveraged businesses in the F&F high book-to-market (value) deciles but that you will find a higher percentage of highly leveraged businesses in the low book-to-market (glamour) deciles.
Other real risk factors include low operating leverage; product obsolescence; low barriers to entry; regulatory risk; loss of suppliers; a concentration of buyers; low current ratios or long periods of low cash flow relative to short-term liabilities, to name a few. These are not mentioned in the F&F literature as risk factors that need to be managed. In fact, the people in the video identify risk with volatility because most of the academic finance literature of the last fifty years identifies risk with volatility.
But the coup de grace to F&F’s riskiness tack came as early as 1994. LSV picked up on F&F’s genuflection to hope and empirically demonstrated in another Journal of Finance article, “Contrarian Investment, Extrapolation, and Risk,” that risk had nothing to do with value’s superior results. LSV (and Haugen, Montier, and many others since LSV) showed that when using the various proxies for risk—Beta, volatility, etc.—they could prove that value stocks exhibited less volatility than glamour stocks. That is, value stocks are significantly less risky than glamour stocks. LSV also showed that in periods of stress—recessions, bear markets, etc.—when risky investments tend to be punished and safe investments tend to be hoarded, value stocks consistently beat glamour.
[1] P. 452
A great analysis of an issue that is perhaps one of the areas of finance which deserves further attention. Cliff Asness has pointed out that despite the extensive literature on the issue, an explanation for the value premium remains a “gigantic, subtle, and still unsettled academic debate.