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1 April 2018 CFA Institute Journal Review

Capturing the Value Premium: Global Evidence from a Fair Value–Based Investment Strategy (Digest Summary)

  1. Karl Strauss, CFA
Temporary deviations of stock prices from their underlying fundamental values allow active value investors to achieve superior risk-adjusted returns within a global investment framework. Real estate stocks’ reporting of assets at fair market values allows their net asset values to act as a proxy for fundamental value to test whether absolute or relative deviations from this value offer better investment opportunities.

How Is This Research Useful to Practitioners?

Most existing research shows value stocks outperforming, on average, broad benchmarks and growth stocks. The value premium from holding value stocks comes with higher fundamental risk, as evidenced by greater return volatility, but the excess return associated with the value premium seems too large to be explained solely by the efficient market hypothesis of compensation for taking on additional fundamental risk.

During the time period examined, value portfolios of real estate stocks outperformed their growth counterparts. In addition, global portfolios outperformed market-level portfolios, and relative mispricing strategies outperformed absolute mispricing strategies. Value portfolios have larger alphas and betas than growth portfolios at the individual market level, but the larger absolute returns and systematic risk of value portfolios translate to better risk-adjusted returns only when compared with globally diversified portfolios.

Value stocks realize a greater benefit from international diversification than from general cross-market diversification. The highest risk-adjusted returns are attributed to a long–short strategy of buying the global real estate stocks trading at the highest discounts to net asset value (NAV) and short selling the stocks with the highest premiums to NAV. This research is beneficial to real estate and value investors and serves as a reminder to all investors of the important benefits of global diversification.

How Did the Authors Conduct This Research?

The FTSE EPRA/NAREIT Global Real Estate Index provides a population of listed equities associated with real estate activities. From this population, a sample of 255 index constituents across 11 markets is selected on the criteria that the company must use International Financial Reporting Standards (IFRS) or a national equivalent to IFRS that requires assets to be reported at fair market value. The time period of the study is January 2005–May 2014, and US companies are excluded because they report historical costs of assets under GAAP rather than fair market values.

At the end of each month, stocks are ranked into quintiles according to their price deviation from intrinsic value as measured by NAV spread. The quintile of stocks trading with the largest discount to NAV represents a value portfolio, while a growth portfolio consists of stocks with the largest premium to NAV. Additional portfolios examined included a long–short portfolio that purchased the largest NAV discounts while shorting the largest NAV premiums, a portfolio consisting of the middle three quintiles, and a benchmark consisting of all stocks in the sample.

All portfolios use equal weightings to control the influence of any individual stock. This strategy is applied at the market level and globally, and a Carhart four-factor model is used to examine the portfolios’ risk and return characteristics. Excess returns are calculated respective of local currency risk-free rates.

Abstractor’s Viewpoint

Investors should be cautious in assuming that the authors’ results will translate broadly to other industries. Although real estate stocks that report the fair market value of assets provide transparency about fundamental net asset value, the characteristics of growth and value stocks within real estate may differ from the characteristics of growth and value stocks in such other industries as pharmaceuticals and technology.

The authors warn against overinterpreting market-level results, because in many cases, the number of portfolio constituents is low. To a lesser extent, I also have concerns about overreliance on the data because the time period is composed largely of the years immediately preceding and following the global financial crisis. In fact, the authors mention that NAV spreads shrunk during the crisis to suggest that growth stocks suffered greater losses during repricing. If the abnormal regime of the financial crisis explains the underperformance of growth stocks, then the conclusion of excess returns tied to the value premium may be overstated.

A variety of risk factors not reflected on balance sheets could influence the results by affecting discounts and premiums to NAV, including investors’ anticipating devaluations, the application of different discount rates, concerns about leverage or anticipated financial distress, or simply a lack of faith in reported appraisal valuations. The authors make a notable comment that earnings surprises are systematically more positive for value stocks than for growth stocks, and although a significant body of research exists in this area, testing this hypothesis with their current dataset could be worthwhile as an area of future research.

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