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The Economics of Value Investing

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The Economics of Value Investing The Economics of Value Investing Kewei Hou∗ Haitao Mo† The Ohio State University Louisiana State University and CAFR Chen Xue‡ Lu Zhang§ University of Cincinnati The Ohio State University and NBER August 2017¶ Abstract The investment CAPM provides an economic foundation for Graham and Dodd’s (1934) Security Analysis. Expected returns vary cross-sectionally, depending on firms’ invest- ment, profitability, and expected investment growth. Empirically, many anomaly vari- ables predict changes in investment-to-assets, in the same direction in which these vari- ables predict returns. However, the expected investment growth effect in sorts is weak. The investment CAPM provides an appealing alternative to the residual income model and Penman, Reggiani, Richardson, and Tuna’s (2017) characteristic model for charac- terizing the cost of capital. In all, value investing is consistent with efficient markets. ∗Fisher College of Business, The Ohio State University, 820 Fisher Hall, 2100 Neil Avenue, Columbus OH 43210; and China Academy of Financial Research (CAFR). Tel: (614) 292-0552. E-mail: [email protected]. †E. J. Ourso College of Business, Louisiana State University, 2931 Business Education Complex, Baton Rouge, LA 70803. Tel: (225) 578-0648. E-mail: [email protected]. ‡Lindner College of Business, University of Cincinnati, 405 Lindner Hall, Cincinnati, OH 45221. Tel: (513) 556-7078. E-mail: [email protected]. §Fisher College of Business, The Ohio State University, 760A Fisher Hall, 2100 Neil Avenue, Columbus OH 43210; and NBER. Tel: (614) 292-8644. E-mail: zhanglu@fisher.osu.edu. ¶We have benefited from helpful comments from Zahi Ben-David, Mike Schwert, Mike Weisbach, Ingrid Werner, and other seminar participants at Department of Finance at The Ohio State University. 1 Introduction In their masterpiece, Graham and Dodd (1934) lay the intellectual foundation for value investing. The basic philosophy is to invest in undervalued securities that are selling well below the intrinsic value. The intrinsic value of a security is the value that can be justified by the issuing firm’s earnings, dividends, assets, and other financial statement information. The underlying premise is that the in- trinsic value justified by fundamentals is distinct from the market value “established by artificial ma- nipulation or distorted by psychological excesses (p. 17).” The academic literature on security anal- ysis, pioneered by Ou and Penman (1989), has largely subscribed to the Graham-Dodd perspective.1 Our key insight is that an equilibrium framework, which we call the investment CAPM, provides an economic foundation for Graham and Dodd’s (1934) Security Analysis, without mispricing. Under the investment CAPM, expected returns vary cross-sectionally, depending on firms’ investment, expected profitability, and expected investment growth. This theoretical prediction validates the widespread practice of security analysis, without contradicting efficient markets. The investment CAPM has different theoretical properties on the cost of capital than the two frameworks that currently dominate the fundamental analysis literature, the residual income model (Preinreich 1938, Miller and Modigliani 1961, Ohlson 1995) and an accounting-based characteristic model (Penman and Zhu 2014, Penman, Reggiani, Richardson, and Tuna 2017). The investment CAPM characterizes the one-period-ahead expected return, which is conceptually different from the internal rate of return in the residual income model. We provide new evidence on how the internal rate of return estimates differ from the one-period-ahead average returns. In addition, we clarify the subtle relations among investment-to-assets, book-to-market, expected investment, and the expected return. While profitability, book-to-market, and expected investment all appear to be 1In particular, Ou and Penman (1989) write: “Firms’ (‘fundamental’) values are indicated by information in financial statements. Stock prices deviate at times from these values and only slowly gravitate towards the fundamental values. Thus, analysis of published financial statements can discover values that are not reflected in stock prices. Rather than taking prices as value benchmarks, ‘intrinsic values’ discovered from financial statements serve as benchmarks with which prices are compared to identify overpriced and underpriced stocks. Because deviant prices ultimately gravitate to the fundamentals, investment strategies which produce ‘abnormal returns’ can be discovered by the comparison of prices to these fundamental values (p. 296).” 1 related to the discount rate in the residual income model, investment-to-assets and book-to-market are largely substitutable in the investment CAPM. Finally, we show that contrary to prior studies (Fama and French 2015), the relation between the expected return and the expected investment tends to be positive in the residual income model, consistent with the investment CAPM. Both the Penman-Reggiani-Richardson-Tuna (2017) model and the investment CAPM focus on the one-period-ahead expected return. However, while Penman et al. use powerful accounting in- sights to relate the expected change in the market equity’s deviation from the book equity to the ex- pected earnings growth, the economic relation between investment and value allows us to substitute, mathematically, the expected capital gain with the expected investment growth. While the market equity remains in Penman et al., the investment-value relation allows us to substitute the market equity with investment-to-assets, making the investment CAPM perhaps even more “fundamental.” While the Penman-Reggiani-Richardson-Tuna (2017) model focuses on the expected earnings yield and book-to-market, which serves as a proxy for the expected earnings growth, as the key drivers of the expected return, the investment CAPM focuses on investment, profitability, and the expected investment growth. Conceptually, the two models scale the expected forward earnings differently, with the market equity in the Penman et al. model and book assets in the investment CAPM. Because of the market equity in their denominators, both the earnings yield and book-to- market effects can be captured by the investment effect. However, the profitability effect in the investment CAPM is outside the Penman et al. model. Finally, while both models feature the ex- pected growth, the Penman et al. model focuses on earnings growth, but the investment CAPM on investment growth. Empirically, factor spanning tests show that the investment and profitability factors subsume factors formed on the earnings yield and book-to-market, but the earnings yield and book-to-market factors cannot subsume the investment and profitability factors. Our work contributes to the fundamental analysis literature in accounting in three important ways. First, we provide an economics-based framework for value investing. Our framework retains 2 the efficient markets hypothesis, departing from the long-standing mispricing perspective per Gra- ham and Dodd (1934). Efficient markets and security analysis are often viewed as diametrically opposite, especially in the investment management industry. In the academic literature, Kothari (2001), Lee (2001), and Richardson, Tuna, and Wysocki (2010) all interpret profits of fundamental analysis strategies as mispricing.2 However, it is well established that time-varying expected returns provide an economic foundation for stock market predictability (Marsh and Merton 1986), without mispricing per Shiller (1981). Analogously, the investment CAPM implies cross-sectionally varying expected returns, which provide an economic foundation for the efficacy of security analysis, without mispricing per Barberis and Thaler (2003). As such, the investment CAPM validates the practice of security analysis on economic grounds, and helps direct analysts’ attention to key determinants of the expected return, including investment, expected profitability, and expected investment growth. Second, the investment policy plays essentially no role in traditional valuation models. For in- stance, the linear dynamics of the residual earnings are exogenously imposed in Feltham and Ohlson (1995) and Ohlson (1995). The linear dynamics ignore the role of growth and abandonment op- tions, which can give rise to nonlinear dynamics (Zhang 2000, Biddle, Chen, and Zhang 2001, Chen and Zhang 2007). In contrast, the investment policy plays a central role in the investment CAPM, which is essentially a restatement of the first principle of capital investment. While the real options studies use a stylized three-period model, we build on an infinite-horizon neoclassical investment model, which is substantially more general and empirically tractable. The investment model also fully captures the real options effect.3 Finally, while the cost of capital is an exogenous constant in the prior studies, the investment CAPM offers a full-blown theory for the expected return. Guided by theory, we also bring the expected investment growth to the center of fundamen- tal analysis, in contrast to its traditional focus on the expected earnings growth (Chan, Karceski, 2These review articles reflect the consensus view of classic, original studies that all adopt the mispricing perspective, such as Ou and Penman (1989), Lev and Thiagarajan (1993), Abarbanell and Bushee (1997, 1998), Frankel and Lee (1998), Dechow, Hutton, and Sloan (1999), Piotroski (2000), Mohanram (2005), and Soliman (2008). 3Abel, Dixit, Eberly, and Pindyck (1996) show that the real options approach and the neoclassical
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