Eugene Fama and Robert Shiller (along with Lars Peter Hanson) received the Nobel Prize in Economics last month for their contributions to understanding asset prices.
But as was frequently noted at the time, Fama and Shiller have very different views on the nature of markets.
Fama, famously, is associated with efficient market hypothesis (EMH) and sees markets as rational, whereas Shiller is noted for his acceptance of a market riddled with behavioral biases.
While both economists are identified with portfolio approaches linked to value investing, Research Afffiliates’ head of equity research, Dr. Vitali Kalesnik, teases out the differences between these approaches — and weighs in on the side of Shiller.
Indeed, in the Southern California-based firm’s November “Fundamentals” newsletter, Kalesnik’s research contribution compares two model value portfolios — helpfully labeled the Eugene Portfolio and the Robert Portfolio — that deliver returns that are miles apart.
Here’s where it is helpful to understand that not everything that is called value is the same. While value investors share a lot in common — both look for stocks with low price-to-fundamentals stock ratios and both agree that value stocks “co-move” with one another.
That said, Fama and Shiller differ in their interpretations of the pricing mechanism, and Kalesnik attempts to show that the implications are profound.
Both would agree that that buying low and selling high is a rewarding strategy. But to Fama, the basis for value’s superiority is risk. Investors are simply being rewarded for assuming more risk.
To Shiller, value investors are being compensated for cleverly exploiting an irrational market’s mispricing of securities.
The Kalesnik paper wonkishly detours to note that empirical studies have disproven various explanations for the source of value stocks’ risk. Neither default risk nor illiquidity explain the performance of value stocks, so it remains an open question what makes this group of stocks more risky, according to the Fama model; current explanations center on hard-to-model systemic or catastrophic risk.
In any event, assuming these two value approaches imply very different portfolios, the Research Affiliates paper tests a Eugene Portfolio that is long risky stocks and short safe stocks, but which is indifferent to book-to-market ratios.
The Robert Portfolio is long cheap stocks (those having high book-to-market ratios) and short expensive stocks (with low B/M ratios), but is indifferent to risk.
Kalesnik and fellow researchers, in a separate study he cites, simulated these two strategies in 23 developed countries spanning many decades and found the Eugene Portfolio generated annualized average performance of 0.79%, which actually implies a negative alpha of -1.74%.
In contrast, the Robert Portfolio yielded an average annual return of 7.61% with a positive alpha of 3.01%. What’s more, Robert’s strategy worked in 100% of the countries under study.
The implication is that it is mispricing (rather than some poorly understood systemic risk) that drives value’s premium returns, and it is specifically book-to-market characteristics that are useful in predicting returns.
Value investors should therefore be much more interested in a tech stock with high fundamentals-to-price ratios, even though it tends to co-move with its fellow “growth” stocks, than a classic “value” stock that co-moves with its ilk but which is priced as an expensive company.
Think an out-of-favor Dell over a much beloved Berkshire Hathaway.
As Kalesnik puts it, “if (as is the case) mispricing and not risk is responsible for value returns, then we can construct more efficient and powerful strategies to extract the value premium”—through cheap stocks that swim with the growth family.
Check out Gundlach on Shiller CAPE Fund: ‘A Better Mousetrap’ on ThinkAdvisor.