SUMMARY

  • Value investors earn a premium for holding undesirable stocks
  • Market skewness may identify periods where the premium is more attractive
  • The returns from the Value factor since 1926 were zero when market skewness was negative

INTRODUCTION

Although buying cheap stocks is intuitively appealing, holding them is highly unappealing for most investors. Value stocks tend to be companies that lack growth, require balance sheet restructuring, feature incompetent management, need a new corporate strategy, are rated “Sell” by brokers, or have some other issue. Effectively Value investors provide a service to the market by holding undesirable stocks.

Historically Value investors were compensated for this service, although with moderate consistency across time. It would be highly desirable to identify the type of environment that is more favorable for harvesting the premium from buying cheap and selling expensive stocks. In this short research note, we will explore using market skewness for improving allocations to the Value factor.

METHODOLOGY

We focus on the Value factor in the US stock market and source data from the library of Kenneth R. French. The performance of the Value factor is derived from a dollar-neutral long-short portfolio of the top and bottom stocks in the US ranked by price-to-book multiples. The data is available from 1926 to 2018, includes companies with small market capitalizations, and excludes transaction costs.

THE VALUE FACTOR & MARKET SKEWNESS

The chart below shows the skewness of the S&P 500 from 1926 to 2018 measured with a 12-month lookback. Positive skewness describes a return distribution where frequent small losses and a few extreme gains are common while negative skewness highlights frequent small gains and a few extreme losses.

The S&P 500’s skewness was slightly negative (-0.2) over the 90-year period. The chart below highlights some of the significant moments in stock market history, e.g. the stock market crash of 1987. We can see that the most recent skewness in 2018 was more extreme than during the Global Financial Crisis, which is explained by the strong returns coupled with the exceptionally low volatility that preceded the market losses of the first quarter of 2018.

S&P 500 Skewness (1926 - 2018)ii

Source: FactorResearch, Stooq.com