By Samuel Lee
A version of this article was published in the March 2014 issue of Morningstar ETFInvestor. Download a complimentary copy here.
My colleague Lee Davidson alerted me to an interesting working paper by Eugene Fama and Kenneth French, "A Five-Factor Asset Pricing Model." Fama and French are famous for their three-factor model, which uses market, value, and size characteristics to explain stock returns. The Fama-French model is taken as holy writ by many investors of the passive persuasion, especially advisors who've been through Dimensional Fund Advisors' boot camp. After more than 20 years, Fama and French have embraced the notion that size and value may not be the best factors to explain stock returns. Their new paper, the first draft of which was released in June 2013, finds that two additional factors - profitability and investment - make redundant the value factor. In other words, value stocks - defined as those with low price/book - only beat growth stocks because they historically tended to be more profitable and less voracious users of capital.
The duo defines profitability as revenues minus cost of goods sold, interest expense, and selling, general and administrative expenses, all divided by book value. Fama and French define investment intensity as the year-over-year growth in total assets.
Interestingly, the profitability and investment factors are negatively correlated. If profitability is a good proxy for return on invested capital, then in theory, we'd expect such firms to have high investment intensity to exploit their opportunities. In practice, high returns on invested capital are often associated with low investment intensity, as such firms have grown into their markets and cannot reinvest all their ample earnings in high-return capital projects. Such firms tend to pay out generous dividends or aggressively buy back shares.
A value tilt is a bet that on average, value stocks will maintain some combination of profitability and investment factor loadings that generate a positive return. Historically, value stocks had the best of both worlds by being both profitable and capital skinflints, but there's no law that says this must be true at all times. In fact, today's most profitable, capital-light firms tend to be "growthier" than they were, say, 15 years ago.
I think this should be a come-to-Jesus moment for those who've taken the F-F model as the gospel truth. Fama and French admit that their original three-factor model was not motivated by theory. They chose value and size because they worked better than other characteristics in back-tests. Grounded in the efficient-market hypothesis, they came up with risk-based stories for these patterns. Small-cap stocks provided excess returns because they're more vulnerable to the business cycle. Value stocks did so because they were distressed.
However, since then, the size factor is no longer considered a significant source of excess returns by many academics and practitioners. Rolf Banz's original 1981 study showing a huge size premium was marred by survivorship bias. After it was corrected in the mid-1990s, back-tests showed a much smaller premium. Moreover, whatever excess returns small-cap stocks provided were driven by the smallest, least liquid securities. Size persists as a widely used factor in academic literature, owing to inertia and the respect Fama and French command.
The value factor has held up a lot better. While the value factor has been found almost everywhere, it's largely been driven by small stocks. While that would seem to support value as a risk factor, it's difficult to actually tie value to some measure of risk. Distressed stocks actually have bad returns.
Fama and French add to the puzzle by finding that the value premium can be explained away as a combination of profitability and investment intensity. An efficient-market theorist would argue that profitable firms and firms with low capital intensity must therefore be riskier in unique ways in order to have commanded return premiums.
Accordingly, Warren Buffett, who famously favors profitable firms with low capital requirements, must then have exploited the special kinds of risks these firms have. And someone who invested in firms with low profitability and huge ongoing investments must have earned lower returns because of such stocks' lower risks. This story defies common sense. I think Buffett's explanation for his success is better: Investors are not perfectly rational and tend to undervalue wonderful firms. By the gold standard of science - the ability to predict patterns in data yet unseen - Buffett's framework passes with flying colors, even if it was never published in a prestigious academic journal.
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