In October 2020, Applied Finance published a research paper (Valuation Beta) that studied the attributes of a comprehensive intrinsic value framework in the context of asset pricing studies popularized by Fama French’s expansion from the CAPM to 3-, 5-, and 6-factor models. This study not only indicated that the Intrinsic Value Factor has delivered significant alpha against asset pricing frameworks reliant on valuation proxies (Book to Price and Dividend Discount Model), but it also provided compelling evidence that factors aligned with intrinsic value and securities analysis principles better explain cross-sectional returns over the past 20+ years compared to academic models that have been subject to recent revision.
“Value” proxies in Fama French’s asset pricing motivations ignore the Wealth Creation Effect of shareholder value created through profitable reinvestment.
- Book to Price, originally posited as the “value” factor in three factor research, only incorporates historical data into its numerator and often conflates high leverage and low profits.
- The later expansion to five factors relied on a Dividend Discount Model proxy for value, which motivated an unconditional preference towards low growth stocks. This implied that high asset growth is a predictor of cross-sectional underperformance regardless of whether incremental investment can generate cash flows in excess of a firm’s cost of capital.
- Applied Finance’s comprehensive intrinsic value framework corrects for these shortcomings by capturing shareholder value created as profits and investment persist over the finite life of the firm. By rewarding profitable investment instead of blindly punishing firms for growing, Valuation Driven portfolios deliver “all weather” attributes that perform well independent of the value/growth cycle observed in traditional style methodologies.
We are excited to share updated results from this asset pricing research study. Our original publication studied US market returns between October 1998 and June 2020. This update now extends our study’s time horizon with an additional year of returns through June 2022.
In this write-up, we introduce a new visual tool to quickly review the annual performance of Applied Finance and popular asset pricing factors in the context of Russell 1000 and Russell 2000 constituents that better align to practitioner needs in real-world portfolio construction.
Russell 1000 Factor Returns:
Russell 2000 Factor Returns:
The common theme through each of these tables is the long-term outperformance of Valuation Driven factors (Intrinsic Value, Financing Yield & Excess Intrinsic Value) & underperformance of Wealth Destroyers (Mgt Qual F), where continued investment by unprofitable firms destroys shareholder value.
The full Valuation Beta asset pricing study and update are available through the hyperlinks below.