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The Investment Premium: Another Factor of Expected Returns

News and Turtle2

A select group of market factors are known to drive stock and bond returns. Some offer fewer advantages to fund investors, such as momentum, which can prove difficult to capture without running up trading and other transactional costs. 

Research by professors Eugene Fama and Kenneth French, however, has uncovered three "dimensions" of investment results that statistically explain 96% of stock returns over time. Better yet, IFA's wealth managers have been able to implement this trio of market factors in a cost-effective and efficient manner for their clients. 

It's known in industry parlance as the Fama/French three-factor model. These are identified as: the excess returns of a stock portfolio over a risk-free investment like a one-month Treasury bill (market factor); company size (market capitalization); and value (the book-to-market ratio, or BtM). 

In addition, a company's profitability has been identified by Fama and French as a reliable dimension of stock returns to consider when putting together diversified global and passively managed portfolios for investors. (See the chart below.)

Market researchers in recent years have also been increasingly discussing negative correlations between higher levels of company investment activity and expected returns. In particular, such an analysis links how firms with higher costs of capital face more challenges in trying to increase corporate investments and grow assets.

Notable work published in this area includes papers by: Fama and French;Michael J. Cooper, Huseyin Gulen and Michael J. Schill;and Efvgeny Lyandres Le Sun and Lu Zhang.

Along these lines, one of the most consequential research pieces we've reviewed of the presence of an investment premium was first published in October 2019 by a pair of analysts at Dimensional Fund Advisors. 

"In plain terms, what our research shows is a company that must invest heavily to sustain its profits should have lower cash flows to investors than a company with similar profits but lower investment. So, if both companies trade at the same price today, this implies that the company with higher investment and lower cash flows has a lower expected return," Savina Rizova, head of research at DFA, tells Index Fund Advisors. 

Along with colleague Namiko Saito, she co-authored the study, "Investment and Expected Stock Returns."In a related blog post that's available for public viewing, they rather succinctly explain the link between a company's level of investment and expected returns to investors. As they put it:

"Valuation theory provides a framework for analyzing the drivers of expected returns. It says that a stock's price reflects expected future cash flows to shareholders discounted to the present through an expected rate of return. Valuation theory therefore predicts that for a given level of expected future cash flows, the lower the stock price, the higher the expected return on the stock. Similarly, for a given stock price, the higher the expected future cash flows to shareholders, the higher the expected rate of return. Expected future cash flows to shareholders are related to the expected future profits of the company. However, not all profits are returned to shareholders because companies may make investments. Therefore, expected investment lowers expected future cash flows to shareholders, holding expected future profits constant."  

In order to quantify any investment premium for investors, Dimensional's research focuses on common methods used by companies to raise capital and grow assets. Those include equity and debt issuance. Rizova and her team also look at a firm's retained earnings as a yardstick. 

Taken on the whole, Rizova generically characterizes a company's issuing new shares of stocks and bonds -- along with its ability to retain earnings  -- as ways to generate "asset growth." 

"This term (asset growth) is key to our research into observing and quantifying the investment premium," she says.

The major takeaway from Dimensional's research, Rizova adds, is how its analysts and portfolio managers have decided to use such findings. While they've also observed a negative correlation between high investment and expected returns, she suggests an implementable investment premium occurs much more prominently in small-cap stocks. 

"It's true we see a negative relationship in both small- and large-cap stocks," Rizova says. "But we find more persistence in small cap stocks, providing greater opportunities to capture the high investment premium in smaller-sized stocks." 

As a result, Dimensional is now excluding stocks showing higher levels of investment across its global family of funds with exposure to small-cap stocks. This includes "smid" (small-mid) and all-cap funds.

Taking into account an investment factor as part of a broader stock selection strategy that includes screening by other dimensions (market, size, value and profitability), can add 0.15% to 0.30% a year on average to a small-cap fund's return over time, Rizova estimates. 

To IFA's investment committee, this is a sound refinement of Dimensional's investment strategy that's built on years of robust academic research. Our wealth advisors welcome implementation of a high investment factor as a way to help  fund investors practically capture a greater share of global small-cap stock returns over the long haul. 

Footnotes:
1.) "Digesting Anomalies: An Investment Approach," Kewei Hou, Chen Xue and Lu Zhang, October 2014 (working paper). 
2.) "Profitability, investment and average returns," Eugene Fama and Kenneth French, Journal of Financial Economics, 2006. "A Five-Factor Asset Pricing Model," Fama and French, Journal of Financial Economics, 2015. "Dissecting Anomalies with a Five-Factor Model," Fama and French, Review of Financial Studies, 2016. 
3.) "Asset Growth and the Cross-Section of Stock Returns," Michael Cooper, Huseyin Gulen and Michael Schill, Journal of Finance, 2008.
4.) "The new issues puzzle: Testing the investment-based explanation," Evgeny Lyandres, Le Sun and Lu Zhang, Review of Financial Studies, 2007.
5.) "Investment and Expected Stock Returns," Savina Rizova and Namiko Saito, Dimensional Fund Advisors, (October 2019).

This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. IFA Index Portfolios are recommended based on investor's risk capacity, which considers their time horizon, attitude towards risk, net worth, income, and investment knowledge. Take the IFA Risk Capacity Survey  at www.ifarcs.com to determine which index portfolio matches your risk capacity.