Value investors generally have to be a tenacious bunch. While everyone knows that value will out in the long run, in the short run it seems to have a torrid time. Within these long periods of underperformance lies the risk that value investors lose their careers in the process - a grim prospect for many. Warren Buffett himself underperformed the market during the dot com bubble by something like 70%. Luckily for him he had the record and authority not lose his job. Others like Tony Dye at the time had no such luck. The risks that value investors deal with in pursuing their strategy are very real. But what if there were a way to mitigate these risks?
In 2008, Cliff Asness, Goldman Sachs alumni and founder of the big quantitative hedge fund AQR Capital, published a research paper titled "Value and Momentum Everywhere" that holds some hope for those value investors willing to broaden their remit. Most investors who've been around markets know that over the long run both value investing and momentum investing work, but something extraordinary appears to happen when they are baked together.
Building the combined value & momentum portfolio
Asness et al decided to study a combined portfolio weighted 50% towards a value strategy, and 50% towards a momentum strategy across a range of asset classes and geographies. Most previous studies had only investigated either value or momentum on their own, usually in an isolated asset class or geography. By investigating 'Value and Momentum Everywhere' the authors were able to highlight a completely global phenomenon - that value and momentum, when brought together create quite remarkably strong returns with remarkably low volatility.
Across the US, UK, Europe and Japan they looked at portfolio returns in not only traditional stock portfolios but also index stock portfolios, currencies, commodities and bonds. Each portfolio was constructed to be market neutral - for the stock picking strategies this meant being long cheap stocks and short expensive stocks (by price to book) and long recent momentum winners and short losers (by 12 month price return). Microcaps, closed end funds, financials and REITs were excluded.
Asness et al found that momentum and value strategies not only provide strong returns, but that they are negatively correlated. What this means in plain english, is that when one strategy works well, the other lags, one zigs when the other zags. Intuitively then, if both strategies are profitable individually, when combined you'd expect the resulting strategy to create a smoother profit line, as the volatility of each components cancels the other out. This is precisely what they found. The combined strategy displays extraordinarily smooth returns not only within single asset classes but also across them. It appears that value combined with momentum works literally everywhere, even during the dotcom bubble that completely devastated value investing returns all over the world. The charts below tell the story quite clearly.
What drives value and momentum?
Why would this phenomenon happen? The study found that value and momentum are only slightly positively influenced by macro-economic factors like GDP growth and only mildly negatively influenced by recessions - "the statistical relation between these macroeconomic indicators and value and momentum strategies is weak". They also looked into the idea that market liquidity risk could be a driver but found that while value strategies suffered during times of financial distress, momentum strategies were enhanced, only "deepening the puzzle".
They then proposed an explanation hinging on the difficulty that arbitrageurs might have in certain market conditions of repricing securities. Personally, that explanation was a little beyond me. I lean towards the behavioural idea that in aggregate investors globally may have a tendency to price stocks badly, creating markets that just aren't efficient - that explains the persistence of these returns enough for me without getting too academic!
Interestingly, the short portfolios contributed enormously to the overall returns. In fact, in the stock selection strategies they found that 60% of profits were driven by short sales of expensive stocks, and 60 to 70% of profits from short selling momentum losers. On the other hand, while the long side of the portfolios are less profitable, they do make up some of the ground by providing better diversification benefits to the portfolio as a whole, smoothing the eventual returns.
United we stand, divided we fall?
These results ought to be quite eye opening for gritty value investors. Instead of clinging to (often rather ugly) value stocks solely on the long side, they ought perhaps to recognise that they are wedded to a single return driver that doesn't work all of the time. If they were to diversify across the uncorrelated and complementary return driver of momentum and hazard on occasion to the short side then they may have better and more consistent results. While not all of us can easily and systematically put a strategy such as the one outlined in the paper into practice, there's a huge amount of food for thought there. It's a long paper and I've hardly scratched the surface in this article but highly recommended.
While Asness et al only modelled value in terms of Low Price to Book in order to maintain a 'simple approach that is consistent across asset classes', he does mention that there are more powerful stock selection strategies for value investors including those of Joseph Lakonishok and Josef Piotroski. For those keen to implement value and momentum strategies in these ways our stock screener models these techniques.