The Illusion of the Value Factor and Alpha

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This is part one of a three-part series.

Despite decades of academics and practitioners promoting the “value factor,”[1] it generates marginal to no long-term alpha. Four reasons have slowed the transition from the accepted “value” regime (low price to something) towards a more robust and realistic true value regime (worth measured independent of market price and focused on the value of future cash flows).

They are:

  1. No theory. There is no clear link between commonly used “value” variables and true value. Yet academics and practitioners have developed no viably accepted competing perspective to explain future returns. As a result, they accept what seems to work and try to expand its application.
  1. Correlation, not causality. Because there is no solid theoretic framework to link accounting book value, earnings, and other such variables to true value, academics and practitioners have explicitly or implicitly focused on improving correlation with returns rather than attempting to create a path to explain causality.
  1. Lack of knowledge. Clearly testing hundreds of ratios until a handful are correlated with future returns is easy with databases and computers. Testing true value is much more difficult as such estimates are not widely available and creating them for backtests is very suspect as it is too easy to inject look ahead biases into DCF valuations. No live database[2] exists, other than Applied Finance’s, which has consistently estimated true values for thousands of stocks globally each week for over 20 years.
  1. Self-interest. With hundreds of billions to trillions invested in the existing value regime, it’s not surprising existing stakeholders will vehemently defend and support current value investing research and practice.

Graham and Dodd believed that true value investing involves deriving the value of a common stock independent of its market price. That theory provides a rational causal relation to test – do stocks trading below their true value, as determined by a particular valuation model, generate higher future returns than those trading above their true value?

The problem with the conventional view of value investing buying low price to some fundamental variable such as book value, earnings, and others) is that, unlike the Graham and Dodd belief, there is no clear theory to test. A low price-to-book ratio does not imply a stock trades below its intrinsic value. While a low price-to--book ratio stock may be undervalued, it may also just describe a fairly valued stock that generates low returns on assets or has few growth opportunities.