It is often assumed that higher levels of inflation bode well for the relative performance of value stocks. The book-to-price (HML) “value premium” was robust over Fama French’s initial study period from 1963 through 1991 when inflation compounded at 5.3%/year. Many traditional value advocates attribute the diminished ex-post returns for value stocks to the lower inflation regime (2.2%/year) experienced since 1992, claiming that this provided an environment more favorable to growth stocks.
With massive levels of stimulus and deficit spending, rising inflation concerns are warranted. Does this mean that investors should anticipate that the HML factor will offer improved performance characteristics if higher inflation materializes? Or is it simply a coincidence that the ex-ante observations on the HML factor occurred in an environment with high inflation, and lower inflation has provided a convenient excuse to absolve nearly 30 years of ex-post underperformance?
Given the prominence of the assumption that inflation is beneficial to value stocks, we believe it is a theme worth exploring in more detail. We acknowledge that there are myriad “value” and “growth” classifications that are common in the investment industry. In this article, we will focus on the classifications offered by Fama French’s HML definition, as low inflation has been commonly cited in defense of the ex-post shortcomings of the book-to-price factor.
Fama French HML Spreads vs. Inflation
Using the recent dataset published by Kenneth French, we can plot the annualized return of HML spreads by decade against annualized inflation rates.
This highlights that high book-to-price, or “value”, stocks outperformed in the 1960s, 1970s, 1980s, and 2000s, but underperformed in the 1990s and 2010s. The 1970s and 1980s were subject to annualized inflation rates in excess of 5%, and HML return spreads were positive in each of those decades on a raw return basis.
Based on this cursory review, it is tempting to assume a positive relationship between inflation rates and HML spreads. But is there an economic foundation to support why high book-to-price stocks should outperform in an inflationary environment? There are a couple perspectives that warrant consideration:
- Leverage: High book-to-price stocks tend to have high levels of leverage. If a firm relies on fixed-rate liabilities, rising inflation provides a benefit by lowering the real value of liabilities, all else equal.
- Profitability: A firm’s profitability can help determine the relative impact of inflation. Short duration stocks earn higher profits in the near-term and quickly return capital to shareholders, while long duration stocks are less profitable today but have expectations for larger profits in the distant future. Distant cash flows are more drastically impacted by compounding inflation, providing a relative benefit for short duration stocks as inflation rises. Profitability can also serve as a proxy for competitive advantage. Firms with strong competitive advantages should be better equipped to raise prices to offset inflationary pressures.
Given these two perspectives that could support why certain companies benefit from inflation on a relative basis, we can turn to the Fama French five-factor model that later introduced the operating profitability (RMW) and investment rate (CMA) factors to isolate the unique contributions of leverage and profitability in asset pricing.
Isolating the Unique Contribution from Leverage
In addition to its popular acceptance as the “value factor”, book-to-price also subsumed a leverage factor in Fama French’s original three factor research.
Using our live datasets from 1998 forward, we observe that portfolios formed on the top 30% of book-to-price stocks have much higher leverage characteristics than the bottom 30% book-to-price basket, confirming that we can use book-to-price as a leverage proxy.
We can then plot the average annual residuals by decade for the HML factor against the remaining factors in Fama French’s five-factor model to determine the unique contribution of the HML factor in asset pricing. The remaining factors include Excess Market Return (Mkt-RF), Size (SMB), Operating Profitability (RMW), and Investment Rate (CMA).
Isolating the unique, unexplained alpha characteristics of the HML factor in a five-factor setting provides a stark contrast against our earlier charts built on raw long-short returns. Residuals are mildly positive in the 1960s and 1970s but fall to negative values in the 1980s despite high inflation over the course of that decade.
Fama French’s expansion to five factors rendered book-to-price redundant between 1963 and 2014, and this chart further highlights that the HML “value premium” was still mild in the 1960s and 1970s before becoming negative from the 1980s forward. It is worth noting that share repurchases were deregulated in 1982 (which directly impacts book equity) and the annualized HML residual by decade has been negative each decade since.
Based on the unique residuals of the HML factor, it does not appear that there is a reliable link between HML’s unexplained alpha and inflation rates to support a leverage theme. While a mild link did exist in the 1970s, it is possible that later accounting changes regarding share repurchases have rendered book-to-price as a weakening leverage proxy over time as share repurchase activity has accelerated.
Isolating the Unique Contribution from Profitability
Investors commonly assume that value stocks are more profitable in the near-term, while growth stocks have low profits today tethered to higher profit expectations in the future. In this dichotomy, profitable value stocks will be less impacted by rising inflation, as they are able to fully return capital to shareholders over a shorter horizon compared to growth stocks. While stock duration is certainly an important consideration when navigating inflationary concerns, it is important to examine whether book-to-price does, in fact, provide a reliable proxy for this theme.
Through a profitability lens, firms that simply earn their cost of capital should trade close to their book value. As profitability increases, investors are willing to pay more for a firm, leading to a lower book-to-price ratio. Because of this relationship, “value” defined by book-to-price ultimately forms portfolios on stocks with low levels of near-term profitability. More importantly, mature, profitable businesses with limited growth opportunities (which allude to shorter-term duration characteristics) become misclassified as low book-to-price (“growth”) stocks when share repurchases diminish book equity levels reported on their balance sheet.
We can review aggregate profitability characteristics using Fama French’s Operating Profitability factor. Under this approach, low book-to-price (or “growth”) stocks have higher levels of operating profits compared to high book-to-price (or “value”) peers. This indicates that book-to-price classifications may provide a terrible proxy for duration characteristics; it is likely that low book-to-price stocks may offer improved duration characteristics due to drastically higher levels of near-term profitability.
We can then further isolate the unique contribution of profitability from leverage by plotting the residual alpha characteristics of Fama French’s Operating Profitability (RMW) factor.
The above chart aggregates the unique, unexplained alpha characteristics of the operating profitability (RMW) factor by decade against the remaining factors in Fama French’s five-factor model. It is noteworthy that the RMW factor has provided positive spreads in each decade, regardless of inflation regime.
In addition to profitability-related themes that allude to duration characteristics, we can also study profitability as a proxy for competitive advantage. Firms with strong competitive advantages are better positioned to be able to raise prices to offset inflationary pressures. To capture this, we can use the Gross Profitability factor, which presumes that higher levels of gross profits provide a proxy for competitive advantage. We can also aggregate Applied Finance’s Economic Margin characteristics, which measures corporate performance from an economic perspective.
Under each of these profitability metrics, low book-to-price (“growth”) stocks have higher levels of gross profits and Economic Margins, implying that they likely benefit from stronger competitive advantage. High book-to-price (“value”) stocks seem to have weak competitive advantages, which may make it difficult for them to raise prices to offset inflationary pressures.
Based on each of these profitability themes, an economic claim tethered to duration or competitive advantage does not support expectations that high book-to-price stocks should outperform in an inflationary environment; instead, it likely supports the outperformance of low book-to-price stocks. Regardless of inflationary regime, this theme will likely be better captured by a profitability factor instead of book-to-price.
Navigating allocation decisions in the face of rising inflation requires more careful stock selection than the current set of passive investment vehicles or factor-based alternatives are equipped to deliver. While there may be a leverage-related theme to consider, the HML factor is likely a weak leverage proxy. It conflates other concepts (valuation, style, leverage, and profitability), which would imply that a direct measure of leverage is likely more reliable. Massive levels of share repurchase activity by mature business with high profits and limited growth opportunities tend to misclassify what would appear to be obvious shorter duration “value” stocks into the “growth” basket due to diminished levels of book equity.
In the context of inflation benefitting Fama French’s HML factor, this ultimately comes down to a determination that inflation will benefit stocks like JPM, BAC, WFC, and C at the expense of AAPL, AMZN, FB, and GOOGL. While that outcome is certainly possible, big banks are likely to have substantial levels of fixed-rate assets (especially after record volume of refinancing in 2020) mismatched against floating rate liabilities which would need to offer higher yields in an inflationary environment. Meanwhile, big tech can simply attempt to raise prices against inflationary pressures due to their strong competitive advantages. To make matters worse, commonly used “value” strategies in practice merge book-to-price with low rates of investment. Firms that combine low profits, minimal growth and limited competitive advantage will likely be ill-equipped to navigate inflationary concerns as nimbly as their wealth compounding peers with high profits, ongoing reinvestment opportunities and stronger competitive advantages.
To better capture leverage, profitability, and competitive advantage themes, investors would be wise to consider a comprehensive intrinsic value framework in stock selection and portfolio construction. Stocks with poor valuation characteristics are likely longer duration due to investors pricing in long-term expectations well above near-term forecasts diminishing over each firm’s unique Economic Profit Horizon. In addition to this, inflation certainly impacts nominal discount rates and the year-over-year comparison of financial statement data, providing further benefits for the use of Applied Finance’s robust valuation framework that adjusts for these impacts. At the very least, investors benefit from separating high profitability “growth” stocks (AAPL, MSFT, AMZN, GOOGL, and FB) from low profitability “growth” stocks (UBER, WDAY, TWLO, SPOT, DOCU) before blanketly assuming that inflation is equally detrimental for growth stocks. Either way, we hope that a more nuanced exploration of relationship between inflation and value stocks provides helpful guidance in forming allocation decisions over the coming years.