Researchers with investment firm Robeco Quantitative Investments suggest that the value premium can be improved upon by using a composite measure instead of solely relying on the book value. They further argue that value strategies can be improved by assessing value at an industry level.

The value factor has suffered a prolonged period of underperformance; thus, many say that the classic high minus low (HML) value factor of Eugene Fama and Kenneth French no longer exists. (HML refers to the returns of high book-to-price stocks, which are value stocks, compared to the returns of low book-to-price stocks, which are growth stocks.) However, researchers David Blitz and Matthias Hanauer suggest some alterations to the generic HML approach to improve the returns of value strategies. The two argue that a healthy value premium can arise by including more value metrics, applying basic risk management techniques and altering the universe of stocks.

Value strategies can be improved upon by not just looking at the book-to-market value ratio (B/M) but by using combination of value metrics. Those metrics include the EBITDA/EV (earnings before interest, taxes, depreciation and amortization to enterprise value) ratio, the cash-flow-to-price ratio and net payout yield.

The researchers also propose an adjustment of “improved risk management” to the value strategy. They consider defining value within industries instead of across industries. By neutralizing industry bets, the study’s authors say they were able to obtain higher risk-adjusted returns.

In addition, they suggest focusing on large and mid-cap companies which are easier to trade. The classic “HML factor gives a disproportionately high weight of 50% to small-cap stocks, which only comprise 10% of the total market capitalization.” The researchers believe that by limiting their focus on liquid large and mid-cap stocks only, they avoid what they describe as “the pitfall that illiquid micro-cap stocks end up dominating the results.”

The suggested enhanced value premium still has suffered poor performance in recent years, even though the strong historical track record shows “a value premia of over 5% for the U.S.” The study’s authors conclude, “with a little bit of effort, a healthy value premium can still be discerned in the cross-section of stock returns. Thus, investors should not jump to the conclusion that the value premium is gone based merely on the weak performance of the generic HML factor.”

Source: “Resurrecting the Value Premium,” by David Blitz and Matthias X. Hanauer; Robeco Quantitative Investments, September 2020.

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