William J. Bernstein
Tastes, Distress, and Jocks
Few concepts in finance are as emotionally challenging to the investing public as the good company/bad stock paradigm. After all, if the purpose of equity ownership is to collect a company’s future earning stream, then doesn’t it make sense to own the most glamorous, rapidly growing firms?
As readers of these pages know, on average, it most certainly does not make sense. Decades of empirical research using almost any balance-sheet metric you care to shake a CRSP shtick at yield the same monotonous result: value stocks have higher returns than growth stocks. It doesn’t matter when—pre-Compustat or post-Compustat—and it doesn’t matter where, whether in the U.S., other developed nations, or in emerging markets. While this concept was a tough sell in the late 1990s, anyone arguing against it now will wind up buried under a mountain of affirmative data, to say nothing of recent returns.
The real mystery is no longer if, but rather why? Behavioralists like Richard Thaler, William Haugen, Josef Lakonishok, and David Dreman believe that the reason is: investors favor growth stocks, thus overpricing them and reducing their expected returns. Conversely, they underprice value stocks, thus increasing their expected returns. In other words, those able to bear the stench of bad companies can belly up for the free lunch.
On the other hand, efficient marketeers, led by Eugene Fama and Kenneth French, posit that value stocks have higher returns because they are riskier and, in particular, point out that value stocks are financially distressed—their balance sheets are so unhealthy that they will blow over in a strong breeze, so investors need to be compensated for this risk.
I’ve always found the behavioralist explanation more satisfying, particularly the data of Fuller, Huberts, and Levinson (Journal of Portfolio Management, Winter 1993), who looked at stocks sorted by price-to-earnings ratio. They found that the top quintile¾ the most popular growth stocks¾increased their earnings by only about 20% cumulatively more than the market over the six years following quintile formation. Perhaps the growth stocks were safer, but so much safer that they warranted multiples several times higher than those in the bottom quintile, while yielding an only slightly larger earnings stream?
Taking a different approach, in a recent working paper John Campbell and his colleagues looked at metrics of market distress and their predictive value, both in terms of subsequent bankruptcy and returns. Without going into all the gory details, the authors identified several new balance-sheet ratios suggestive of company distress that did a dandy job of predicting future bankruptcy—much better than the traditional techniques (such as Altman’s Z-score and Ohlson’s O-score—you don’t want to know . . . ). The Fama-French risk hypothesis predicts that distressed companies identified by these techniques should have higher returns than the market. Alas, no: The most distressed companies had returns that were much lower than those of the least distressed companies, with multifactor alpha spreads on the order of 20% per year. About the only way an efficient-market enthusiast can wiggle his way out of this one is to posit dimensions of risk beyond company failure—a tall order (or else yell "data mining!" at the top of his lungs).
Even Fama and French have gotten into the act. (Note, the link to the SSRN Web site may require a free registration.) They postulate a world consisting of two types of investors: "A," informed investors, and "D," uninformed investors. (You can guess what the "D" stands for.) The major difference between the two classes is that D investors have "tastes and preferences" for assets that go beyond mere returns, whereas A investors own assets merely based on mean-variance considerations. What kinds of things count as "tastes and preferences?" Glamorous growth stocks top the list of the usual suspects. But there are others: home-country bias and socially responsible investing come easily to mind. Their piece contains no empirical data and certainly concedes no ground to the free-lunch crowd, but rather provides a theoretical framework within which to test behavioral hypotheses.
At this point, I cannot resist tooting my own puny horn. Several years ago, I proposed the "investment entertainment pricing theory," (INEPT), which postulated that all securities had two return components—a financial return and a entertainment return—and that these two were complementary. That is, a security with high entertainment return tended to have a low investment return, and vice versa. A brief Google search for this model shows only one hit, which is my original piece, so I deduce that it did not gain a lot of traction. But my intent was at least half serious; I think there’s a thesis project in this for anyone who can develop a workable parameter with which to measure investment entertainment value. I would suggest media citations/market cap as a first slap.
My personal favorite among D investor tastes and preferences is the jock factor. American males have a near-pathologic desire to associate themselves with current and retired professional athletes. Even the haughtiest master of the universe will slobber over an NBA point guard, and otherwise sensible grown men regularly pay thousands of dollars to go to baseball camps with septuagenarian shortstops who view their clients with the same amount of respect that table dancers do theirs.
Financial services companies are aware of the jock factor and exploit it to the hilt. One of the most stunning demonstrations showed up in the credits at the end of "Miracle," an excellent film about the victory of the U.S. ice hockey team in the 1980 Winter Olympics. Fully half of the gold-medal winners wound up in the financial services industry, most of them in brokerage. Perhaps there is a previously undescribed high correlation between financial acuity and skill on skates, but somehow one doubts it. Each year, U.S. investors lose billions in returns for the privilege of associating themselves with the superannuated athletic heroes hired in droves by brokerage houses and insurance companies.
The behavioralists cannot yet be declared the winners of the value-premium debate, but when the two giants of the efficient-market hypothesis openly speculate about investors purchasing consumption goods in the capital markets, that time cannot be very far off.
Copyright © 2005, William J. Bernstein. All rights reserved.
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