A Come-to-Buffett Moment
Eugene Fama and Kenneth French's new five-factor model buries the value factor. What does it suggest about market efficiency?
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.HT: The Reformed Broker
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....MORE
