Miscellaneous Strategies

"We define a quality security as one that has characteristics that, all-else-equal, an investor should be willing to pay a higher price for: stocks that are safe, profitable, growing, and well managed. High-quality stocks do have higher prices on average, but not by a very large margin. Perhaps because of this puzzlingly modest impact of quality on price, high-quality stocks have high risk-adjusted returns. Indeed, a quality-minus-junk (QMJ) factor that goes long high-quality stocks and shorts low-quality stocks earns significant risk-adjusted returns in the U.S. and globally across 24 countries. The price of quality varies over time, reaching a low during the internet bubble, and a low price of quality predicts a high future return of QMJ. Analysts’ price targets suggest that the required return of quality stock is low despite the high realized return."

"Many market observers point to the very high fraction of earnings retained (or low dividend payout ratio) among companies today as a sign that future earnings growth will be well above historical norms. This view is sometimes interpreted as an extension of the work of Miller and Modigliani. They proved that, given certain assumptions about market efficiency, dividend policy should not matter to the value of a firm. Extending this concept intertemporally, and to the market as a whole, as many do, whenever market-wide dividend payout ratios are low, higher reinvestment of earnings should lead to faster future aggregate growth.

However, in the real world, many complications exist that could confound the expected inverse relationship between current payouts and future earnings growth. For instance, dividends might signals managers' private information about future earnings prospects, with low payout ratios indicating fear that the current earnings may not be sustainable. Alternatively, earnings might be retained for the purpose of "empire-building," which itself can negatively impact future earnings growth. We test whether dividend policy, as we observe in the payout ratio of the market portfolio, forecasts future aggregate earnings growth. This is, in a sense, one test of whether dividend policy "matters." The historical evidence strongly suggests that expected future earnings growth is fastest when current payout ratios are high and slowest when payout ratios are low. This relationship is not subsumed by other factors such as simple mean reversion in earnings. Our evidence contradicts the views of many who believe that substantial reinvestment of retained earnings will fuel faster future earnings growth. Rather, it is fully consistent with anecdotal tales about managers signaling their earnings expectations through dividends, or engaging in inefficient empire building, at times; either of these phenomena will conform with a positive link between payout ratios and subsequent earnings growth.

Our findings offer a challenge to optimistic market observers who see recent low dividend payouts as a sign of high future earnings growth to come. These observers may prove to be correct, but history provides scant support for their thesis. This challenge is potentially all the more serious, as recent stock prices, relative to earnings, dividends and book values, rely heavily upon this expectation of superior future real earnings growth."

"The "Fed Model" has become a very popular yardstick for judging whether the U.S. stock market is fairly valued. The Fed Model compares the stock market's earnings yield (E/P) to the yield on long-term government bonds. In contrast, traditional methods evaluate the stock market purely on its own without regard to the level of interest rates. My goal is to examine the theoretical soundness, and empirical power for forecasting stock returns, of both the "Fed Model" and the "Traditional Model". The logic most often cited in support of the Fed Model is that stocks should yield less and cost more when bond yields are low, as stocks and bonds are competing assets. Unfortunately, this reasoning compares a real number to a nominal number, ignoring the fact that over the long-term companies' nominal earnings should, and generally do, move in tandem with inflation. In other words, while it is a very popular metric, there are serious theoretical flaws in the Fed Model. Empirical results support this conclusion. The crucible for testing a valuation indicator is how well it forecasts long-term returns, and the Fed Model fails this test, while the Traditional Model has strong forecasting power. Long-term expected real stock returns are low when starting P/Es are high and vice versa, regardless of starting nominal interest rates. I also examine the usefulness of the Fed Model for explaining how investors set stock market P/Es. That is, does the market contemporaneously set P/Es higher when interest rates are lower? Note the difference between testing whether the Fed Model makes economic sense, and thus forecasts future long-term returns, versus testing whether it explains how investors set current P/Es. If investors consistently confuse the real and nominal, high P/Es will indeed be contemporaneously explained by low nominal interest rates, but these high P/Es lead to low future returns regardless. I confirm that investors have indeed historically required a higher stock market P/E when nominal interest rates have been lower and vice versa. In addition, I show that this relationship is somewhat more complicated than described by the simple Fed Model, varying systematically with perceptions of long-term stock and bond market risk. This addition of perceived risk to the Fed Model also fully explains the previously puzzling fact that stocks "out yielded" bonds for the first half of the 20th century, but have "under yielded" bonds for the last 40 years. Finally, I note that as of the writing of this paper, the stock market's P/E (based on trend earnings) is still very high versus history. A major underpinning of bullish pundits' defense of this high valuation is the Fed Model I discredit. Sadly, the Fed Model perhaps offers a contemporaneous explanation of why P/Es are high, but no true solace for long-term investors."

"This study provides new evidence on anomaly interactions, as well as on the cross-section of returns in all-but-microcap universe of U.S. stocks over the 42-year sample period from 1971 to 2013. The five anomalies being examined are size, value, profitability, investment/asset growth, and momentum. We form 5x5 conditional double-sort portfolios for each pair of anomaly variables, resulting in 20 different 5x5 sorts when using each variable in the first-stage sorting and the remaining four in the second-stage sorting. The interrelation between each pair of anomaly variables is evaluated on the basis of the monotonic relation (MR) test of Patton and Timmermann (2010) for portfolio raw returns, and in addition, by means of the Sharpe ratio comparisons. Moreover, we run Fama-MacBeth (1973) cross-sectional regressions to compare the relative explanatory power of each variable in the presence of the others. The results show that investment/asset growth and momentum dimensions capture the cross-sectional return patterns better than size, value, or profitability. The relative efficacy of momentum is higher in all-but-microcap universe than previously documented for the corresponding unlimited market-cap samples of U.S. stocks."

"This paper shows that portfolios of more investable securities bear a premium when compared to portfolios of less investable stocks, reflecting compensation for local risk factors. The investable premium is overwhelmingly priced across 3,782 companies traded in 29 emerging markets from 1988 to 2006. The investable premium impacts stock returns at least as much as other fundamental premiums such as size, value, momentum, and loads on political, economic, and financial risk factors. The impact of the investable premium on emerging stocks returns has increased in strength, implying that foreign ownership has greater influence on local markets in recent years."

"Utilising a comprehensive data set for Australian firms, we examine a range of competing asset-pricing models, including the four- and five-factor models where the equity-risk premium is augmented by size, value, momentum and liquidity premia, and find that none of the models tested appears to adequately explain the cross section of Australian returns. A model accounting for Australia's integration with the US equity market appears to be the best of the competing models we study. Our argument that a model recognising Australia's integration with the USA is supported when we apply the portfolio and factor construction methodology suggested by Brailsford et al."

"The purpose of this paper is to understand the linkages between excess returns and four investment strategies - value, momentum, size, and liquidity - for the Vietnam stock market during the period 2006-2014. The empirical results suggest that a value strategy, such as the E/P and B/P ratios, and momentum and liquidity strategies are the most successful and generate significant excess returns, in contrast to the size strategy, which does not workin the Vietnam stock mark. Therefore, investors who want to make a profit when investing in the Vietnam stock market should track published financial information and find winner stocks by referring to value, momentum, and liquidity strategies."

"The multifactor investing framework has become very popular in the indexing community. Both academic and practitioner researchers have documented hundreds of equity factors. But which of these factors are likely to profit investors once implemented? We find that many of the documented factors lack robustness. Size and quality, two of the more prominent factors, show weak robustness, whereas value, momentum, illiquidity, and low beta are more robust. Further examining implementation characteristics, we find that liquidity-demanding factors, such as illiquidity and momentum, are associated with significantly higher trading costs than are other factors. Investors may be better off accessing these factors through active management rather than indexation."

"A great number of international studies suggest that certain firm-specific factors contribute significantly to explaining the cross section of equity returns. Specifically, factors capturing value, momentum and size effects are observed to be the most substantial in this regard. The majority of South African studies suggest that similar effects are present on the Johannesburg Securities Exchange (JSE). The South African equity market is regarded as a highly concentrated, less liquid market relative to those of developed markets. Therefore liquidity could have a significant impact on the results of studies concerning the cross section of equity returns on the JSE. In this study the impact of liquidity on the identity and explanatory power of firm-specific factors regarding the cross-section of returns are examined. Our results suggest that there is a strong, robust value effect on the JSE, while the significance associated with the size and momentum effects reported in prior studies are in fact sensitive to the level of sample liquidity."

"When assessing a fund manager's skill, sophisticated investors will consider all factors (priced and unpriced) that explain cross-sectional variation in fund performance. We investigate which factors investors attend to by analyzing mutual fund flows as a function of recent returns decomposed into alpha and factor-related returns. Surprisingly, investors attend most to market risk (beta) when evaluating funds and treat returns attributable to size, value, momentum, and industry factors as alpha. Using proxies for investor sophistication (wealth, distribution channels, and periods of high investor sentiment), we find that more sophisticated investors use more sophisticated benchmarks when evaluating fund performance."