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Of academic value

 Salomons Judgement

In my lectures and in conversations with clients I always proclaim that value is better than growth. But to what extreme can the elastic band be stretched?

The average reader may not jump with joy after hearing the names of Nobel laureate Eugene Fama and Ken French, so here is their lesson for investors. In one of the most quoted papers from 1993, the duo describes that investors in small caps and value stocks achieve excess returns, more than compensating for the extra risk taken. In other words, the market is not always efficient. After this pioneering work, a series of studies into other market anomalies followed. A few weeks ago, I met French in person. He is not only one of my academic heroes, but also a nice man with wise lessons for investors.

To date, only a few factors have sufficient theoretical underpinnings or have survived empirical scrutiny. That’s also the first lesson, where statistics can help. When the theoretical foundation is fragile, the data must be convincing. When the theory is stronger, the first setback doesn’t mean that everything needs to be thrown overboard immediately. The first concerns the momentum factor, measured as the difference in returns over the last year: winners minus losers. The second applies to small caps and value stocks.

Buying the winners isn’t working anymore and hasn’t been for the last ten years. Is that enough to reject the factor? Not yet. Even ten years is still too short for that. The data in the previous years was strong enough. With the small-cap effect, the theory is better substantiated, but the data has been lagging behind for much longer. Still not an instant problem, but you can tell that there is more doubt. It takes too long and the stats are not that strong. At lunch, French was sitting at our table and I heard him say that he has begun to doubt the sustainability of the effect. Striking words from the discoverer, who immediately came up with a number of citations showing that it happens more often that effects disappear after publication. But so far, nothing more than doubts. Most recently, small caps have done well.

That brings me to value stocks. I still believe that buying cheap pays off. In lecture halls and in meeting rooms with customers, I call for value over growth. But every time, Tesla, Netflix and Amazon shares break records. Value has lagged behind growth for over ten years and the difference in valuation between growth and value stocks has never been so extreme. That is often a good predictor for a return to the trend. However, the extent to which value shares lag behind is not as extreme as seen in the past. In earlier periods in which value lagged behind growth for a long time, portfolio managers were dismissed due to a lack of performance. That is also not the case, yet.

It made me come up with a nice question for French: to what extreme can the elastic band be stretched? How long before it bounces back? He had remained silent for a while before he answered: “The standard errors in the regression are too large, so I can’t say.” A bit thoughtless I answered that I thought that was quite an academic answer, after which he grabbed my arm and said: “That is the true answer, remember that! Academics are always in pursuit of the truth.”

I won’t get away with that in a column. The probability that value stocks will do better than growth stocks I think is higher than 50%, also in the short term. And if we get a substantial correction in equity markets in the near future – which is quite possible concerning the withdrawal of liquidity – then this scenario will only become more likely.

The author

Roelof Salomons


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