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Anna Beukes February 2011 Northern Alberta Institute of Technology.

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1 Anna Beukes February 2011 Northern Alberta Institute of Technology

2  Value stocks refer to those trading at low prices relative to fundamental values such as earnings, book value of assets, and cash flow  Fama & French (1992) showed that stocks of value companies outperformed that of growth companies

3  Value premium tested extensively and widely in various ways, in Japan (Chan, Hamao and Lakonishok, 1991); France, Germany, Switzerland and the UK (Capaul, Rowley and Sharpe, 1993).  Findings of the value premium existence very consistent, irrespective of method or country

4  Investigated by various researchers  Most extensive recent test done by Beukes (2010): using 30 years worth of data and more than one method of portfolio formation.

5  The results are very convincing:  Value portfolios consistently outperformed growth portfolios, regardless of ◦ the length of time the portfolios were carried (one to five years), or ◦ whether returns were recorded annually (year-on- year) or for holding purposes (on a buy-and-hold basis). ◦ Even after size-adjustment, value portfolios still outperformed growth portfolios by an impressive margin.

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8  Academic community has generally come to agree that value investment strategies, on average, outperform growth investment strategies (Chan and Lakonishok, 2004:71)  But, still no agreement on how to explain the value premium.

9 Risk as (default) explanation  Assuming market efficiency, value premium is a measure of risk – indicating a higher discount rate that compensates investors for carrying higher risk.  What risk? Beta

10  After “uncovering” the value premium, Fama and French (1992) immediately tested beta as explanation and found no evidence that value companies are inherently more risky  Had to admit that: …“our bottom-line results are [that] beta does not seem to help explain the cross-section of average stock returns…” (1992:428).

11  Van Rensburg (2003) found beta does not explain the cross-section of average returns in SA either.

12  Maybe beta “too crude” a risk measure  Heaton and Lucas (1997): value companies vulnerable to recessions, business cycle downturns  Xing and Zhang (2004): fundamentals of value firms more adversely affected by negative business shocks than that of growth firms

13  Liew and Vassalou (1999) tried to link value firm returns to macro-economic events  Jagannathan and Wang (1996) and Reyfman (1997) used labor income as a factor to explain the value premium =>To date no convincing/conclusive evidence that distress factors provide the explanation

14  Lakonishok, Shleifer and Vishny (henceforth LSV, 1994): systematic mispricing of value and growth stocks caused by investors who naively extrapolate the past growth rates of firms  Value stocks - a past history of poor performance (relative to growth stocks) with respect to growth in earnings, cash flow and sales  Investors overestimate sustainability of high returns on growth stocks; project past growth too far into the future.

15  LSV summarized it as follows: “The essence of extrapolation is that investors are excessively optimistic about glamour stocks and excessively pessimistic about value stocks because they tie their expectations of future growth to past growth.” (Lakonishok, Shleifer and Vishny, 1994: 1559)

16  Test for extrapolation: look at future growth rates; compare them to past growth rates.  Must be shown that growth companies performed well in the past; that investors expected strong growth to continue in the future.  Similarly, it must be shown that value companies performed badly in past; are expected to continue to perform poorly in the future.

17  It is possible to test this notion, because past performance and future expectations are two distinct and separate entities which can be evidenced.  Past performance measured by past growth in sales, earnings and cash flow.  Expectations about the future reflected by multiples of stock price to earnings and cash flow.

18  Book-value-to-market-value (BV/MV) used for portfolio formation  Five years of pre-portfolio formation data necessary to test for extrapolation - portfolio formation started in 1977  Three portfolios (top 30%, middle 40% and bottom 30%) formed annually - top 30% the value portfolio, bottom 30% the growth portfolio

19 For each of the two extreme portfolios the following variables were tracked:  Past performance (i.e. in the five years before portfolio formation) of growth in sales, earnings and cash flow.  Future performance (i.e. in the five years after portfolio formation) of growth in sales, earnings and cash flow.

20  Ratios such as E/P (earnings/market value of equity) and C/P (cash flow/market value of equity) at portfolio formation.  These ratios give an indication of investors’ expectations of what will happen in the future.

21 ValueGrowth Growth in… Before portfolio formation After portfolio formation Before portfolio formation After portfolio formation Sales16.46%17.07%21.01%19.73% Cash flow21.10%29.82%32.07%28.03% EPS (excluding extra-ordinary items)28.04%31.05%27.82%25.00% Multiples…at portfolio formation ValueGrowth Cash flow/Price EPS/Price

22  Analysis of Johannesburg Stock Exchange data for the existence of a value premium unambiguously confirms that the premium also occurred in South Africa between 1972 and 2001  The major remaining questions: - what could explain this? - what does the value premium suggest about the tenability of rational finance theory?

23  Risk: Are there “distress factors” not captured by beta (systematic risk)? ◦ Fama & French (1993): “Yes” ◦ Lakonishok, Shleifer & Vishny (1994): “No” ◦ Despite substantial research and arguments, debate rages on inconclusively

24  Extrapolation: Incorporate “less than rational” decision-making into financial markets (DeBondt & Thaler, 1985) – the more likely explanation  “Less than rational” investors extrapolate past results too far into the future - for both value and growth stocks  “Irrational” behaviour will not disappear - rather an enduring characteristic of behaviour in financial markets


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