Valuation Beta – 2021 Asset Pricing Study Update

Excess Intrinsic Value Motivation

Applied Finance’s Valuation Beta Research Paper studies the unique characteristics of the Intrinsic Value Factor^™ in asset pricing. We believe this research is an important contribution to asset pricing literature, not only due to the unique alpha characteristics and the improved ability to explain crosssectional returns derived from systematic intrinsic value estimates, but also due to the implications that call for a reconciliation between the divergent perspectives in quantitative finance and securities analysis.

We have recently updated this study to include performance through June 2021, providing nearly 23 years of US market returns in this format. In the charts and tables below, we have updated the performance characteristics of studies that provided the motivation for the Excess Intrinsic Value factor in asset pricing.

Table 1 highlights that the Applied Finance Intrinsic Value Factor™ provides 3.57% of statistically significant annualized alpha when regressed against the Fama French 5 Factor model. In this same test for factor redundancy, Book to Price provides -5.18% of statistically significant negative alpha, and each of these “value” factors share a high degree of multicollinearity.

Table 2 (and it’s accompanying line chart) explores the contrast between Intrinsic Value and Book to Price. We form portfolios on the competing cheap/expensive and undervalued/overvalued portfolio assignments. This provides compelling evidence that undervalued stocks that are not cheap significantly outperform stocks that are cheap, but not undervalued.

The formulas below table 2 highlight how the common “book value” term can be rearranged to calculate Excess Intrinsic Value to diminish the multicollinearity observed between Book to Price and the Intrinsic Value Factor™.

Table 3 reflects a test for factor redundancy between Excess Intrinsic Value and Fama French’s 5 Factors. Excess Intrinsic Value provides unexplained annualized alpha of 2.13% while Operating Profitability becomes insignificant, indicating that the discounted value of persistent Economic Profits is more useful than a single year ROE-based measure. Swapping Excess Intrinsic Value for Operating Profits in an adjusted 5 factor model in Table 4, Excess Intrinsic Value provides 7.60% of alpha unexplained by the remaining factors.

In our asset pricing research, we noted a material inconsistency between the role of asset growth in quantitative finance and securities analysis. Incremental investment in projects that earn more than a firm’s cost of capital should increase a firm’s intrinsic value, while investment in projects that earn less than a firm’s cost of capital will destroy shareholder value. This concept is captured in Applied Finance’s Wealth Creation Matrix, and it is a perspective that is common in corporate finance and capital budgeting decisions.

In the expansion to 5 factors, however, Fama French provided motivation to independently prefer stocks with high profitability and low growth characteristics. This claim that high levels of asset growth predict underperformance is inconsistent with the conditional role of investment in our valuation framework. We agree that high asset growth is problematic for unprofitable firms, but profitable reinvestment offers wealth compounding benefits that unlock shareholder value.

Studying Fama French’s 5 Factor paper, we observed that their interpretation that led to two distinct factors could be reinterpreted as a single factor focused on yield derived from firm-wide financing cash flow. This single factor interpretation eliminates the problematic claim that asset growth is unconditionally a predictor of underperformance. Instead, high growth fueled by external financing due to weak profitability can be captured by the “diluting ownership” portfolio.

Table 5 highlights that a single-factor Financing Yield interpretation contains additional unexplained alpha when regressed against Fama French’s 5 Factors, while Operating Profits and Investment Rate become redundant when regressed against Financing Yield. Table 6 then replaces the RMW & CMA factors with Financing Yield, which provides significant annualized alpha of 8.32%.

Table 7 highlights the performance of portfolios formed on Applied Finance’s Excess Intrinsic Value and Financing Yield factors, a combination we refer to as “Valuation Stewardship”. On a cap-weighted basis, high Valuation Stewardship stocks have returned 14.65% per year, while low Valuation Stewardship stocks have returned 7.93% per year.

2021 Factor Performance Update

Equipped with our expanded set of monthly returns through the end of June 2021, we can review updated performance of asset pricing factors and their underlying 2×3 portfolios derived by NYSE-based size and factor breakpoints. The annualized return reflects cap-weighted returns between October 1998 and June 2021, while rolling 12M returns reflect the new data appended to our study from July 2020 to June 2021.

• Intrinsic Value Factor™ (IV): Since 1998, top 30% has outperformed bottom 30% by 5.3% per year in large cap stocks and 5.3% in small cap stocks. Over the previous 12 months, top 30% outperformed bottom 30% by 16.9% in large cap stocks and 31.9% in small cap stocks.
• Excess Intrinsic Value (VMC): Since 1998, top 30% has outperformed bottom 30% by 5.9% per year in large cap stocks and 5.1% in small cap stocks. Over the previous 12 months, top 30% underperformed bottom 30% by -10.9% in large cap stocks (while outperforming overall market by 2.6%) and 24.9% in small cap stocks.
• Financing Yield (RMD): Since 1998, top 30% has outperformed bottom 30% by 6.9% per year in large cap stocks and 6.9% in small cap stocks. Over the previous 12 months, top 30% outperformed bottom 30% by 1.8% in large cap stocks and 30.3% in small cap stocks.
• Debt / Enterprise Value (DME): Since 1998, top 30% has underperformed bottom 30% by -0.8% per year in large cap stocks and outperformed by 1.5% in small cap stocks. Over the previous 12 months, top 30% outperformed bottom 30% by 8.8% in large cap stocks and 47.3% in small cap stocks.
• Book to Price (HML): Since 1998, top 30% has underperformed bottom 30% by -2.7% per year in large cap stocks and outperformed by 1.5% in small cap stocks. Over the previous 12 months, top 30% outperformed bottom 30% by 18.1% in large cap stocks and 21.4% in small cap stocks.
• Operating Profitability (RMW): Since 1998, top 30% has outperformed bottom 30% by 6.4% per year in large cap stocks and 3.6% in small cap stocks. Over the previous 12 months, top 30% underperformed bottom 30% by -8.6% in large cap stocks and outperformed by 18.2% in small cap stocks.
• Investment Rate (CMA)*: Since 1998, bottom 30% (conservative growth) has outperformed top 30% (aggressive growth) by 1.4% per year in large cap stocks and 5.9% in small cap stocks. Over the previous 12 months, bottom 30% outperformed top 30% by 4.0% in large cap stocks and 20.8% in small cap stocks. (*CMA factor is bottom 30%-top 30%)
• Price Momentum (1 Year ex 1 Month) (UMD): Since 1998, top 30% has outperformed bottom 30% by 4.6% per year in large cap stocks and 5.8% in small cap stocks. Over the previous 12 months, top 30% underperformed bottom 30% by -24.7% in large cap stocks and -1.9% in small cap stocks.

Practical Application in Large Cap Portfolio Construction

Valuation Stewardship combines the Excess Intrinsic Value and Financing Yield factors motivated from our asset pricing research. Shifting our focus away from the all-cap US (exADR/REIT) universe common in asset pricing, we can explore practical implications by forming broadly diversified portfolios on index constituents and compare the risk-adjusted performance of a Valuation Stewardship strategy to its index benchmark.

From the recently reviewed asset pricing material, the Excess Intrinsic Value factor has provided significant unexplained alpha when forming cap-weighted long-short portfolios since 1998. In addition to this performance derived from stock selection, enhanced risk-adjusted characteristics are also observed when Excess Intrinsic Value is used to form position sizes in value-weighted indexing across all index constituents.

To form broad Valuation Stewardship portfolios, we first exclude stocks based on negative Financing Yield characteristics which suggests that external financing is required to meet reinvestment needs in excess of organically-generated cash flow. We then form position sizes on remaining constituents as a function of intrinsic value characteristics in excess of common stock levels already reported on the balance sheet.

Starting with the Russell 1000, the Valuation Stewardship index outperforms its Russell 1000 benchmark by 2.4% per year. It also outperforms the accompanying cap-weighted portfolio of stocks not held in the portfolio (Valuation Stewardship Do Not Add) by 4.0% per year.

On a risk-adjusted basis, the Valuation Stewardship approach to portfolio construction delivers higher Sharpe ratios, an information ratio of 43.3%, lower draw downs, lower beta, and lower standard deviation of monthly returns. The accompanying Do Not Add list underperforms the Russell 1000 index with lower Sharpe ratios, an information ratio of -17.4%, higher draw downs, higher beta, and higher volatility.

Within each AFG sector, the Valuation Stewardship strategy has outperformed the cap-weighted benchmark in all sectors except Utilities, Health, and Consumer Durable. On average, this strategy holds slightly more than half of all Russell 1000 constituents, with an average active share of 42.4% This active share has largely been contributed from Financials, Consumer Services, Technology and Health sectors.

Weighted intrinsic value characteristics (using estimates that incorporate consensus forecasts through 2024) of the Valuation Stewardship strategy offer robust upside compared to its cap-weighted benchmark and the accompanying Do Not Add list. While the overall Russell 1000 Index currently offers intrinsic value upside of 2.6%, the Valuation Stewardship portfolio offers increased upside of 38.8% (due to position sizing based on intrinsic value characteristics and the exclusion of overvalued dilutive stocks). The current valuation gap of 60.7% between the Valuation Stewardship portfolio and its accompanying Do Not Add list is the highest valuation gap on record since 1998 and nearly 2.4 standard deviations above its normal average.

Practical Application in Small Cap Portfolio Construction

Shifting our focus to small cap US stocks, the Valuation Stewardship index outperforms its Russell 2000 benchmark by 3.8% per year. It also outperforms the accompanying cap-weighted portfolio of stocks not held in the portfolio (Valuation Stewardship Do Not Add) by 4.9% per year.

On a risk-adjusted basis, the Valuation Stewardship approach to portfolio construction delivers higher Sharpe ratios, an information ratio of 45.9%, lower draw downs, lower beta, and lower standard deviation of monthly returns. The accompanying Do Not Add list underperforms the Russell 2000 index with lower Sharpe ratios, an information ratio of -12.5%, higher draw downs, higher beta, and higher volatility.

Within each AFG sector, the Valuation Stewardship strategy has outperformed the cap-weighted benchmark in all sectors except Consumer Non Durable. On average, this strategy holds slightly less than one third of all Russell 2000 constituents, with an average active share of 64.6% This active share has largely been contributed from Financials, Consumer Services, Technology and Health sectors.

Weighted intrinsic value characteristics (using estimates that incorporate consensus forecasts through 2024) of the Valuation Stewardship strategy offer robust upside compared to its cap-weighted benchmark and the accompanying Do Not Add list. While the overall Russell 2000 Index currently offers intrinsic value upside of -4.5%, the Valuation Stewardship portfolio offers increased upside of 56.6% (due to position sizing based on intrinsic value characteristics and the exclusion of overvalued dilutive stocks). The current valuation gap of 75.6% between the Valuation Stewardship portfolio and its accompanying Do Not Add list is slightly below the valuation gap recorded during the tech bubble and more than 2.4 standard deviations above its normal average.

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