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The 'Migration' Effect: How M&A Activity Plays into Value Premiums

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Academic research points to a premium for long-term investors who tilt their portfolios to value-styled stocks as opposed to growthier names. It's a topic studied by many scholars, including seminal work by Eugene Fama and Kenneth French.1

In general, value stocks are defined as having discounted prices based on some financial fundamental measure tied to sales, net income, dividends or book value. At IFA, we've found a company's book-to-market (or net asset value) to be an especially worthwhile metric worth tracking. This ratio basically measures what a company owns minus what it owes. 

Another key calculation our portfolio management and research team watches is an investor's expected rate-of-return, which is driven by prices paid and cash flows someone can expect to receive.

Besides identifying such a style premium exists, another body of work has delved into the so-called migration effect. It's based on research by Fama and French seeking to quantify different patterns of movement across value and growth categories. The table below shows expected returns of value versus growth stocks over longer periods and broken down by asset class. (It also displays such data for other factors identified by academic research as driving longer-term stock market returns, namely market capitalization size and profitability.) 

In their seminal study simply titled "Migration," the two professors point to a major factor in driving expected returns for value stocks has come from a boost provided by mergers and acquisitions (M&A).2

Over an extended period studied (1927-2006), Fama and French found that such activity contributed significantly to value's outperformance, both in small caps as well as large caps. But depending on circumstances and periods reviewed -- characterized as "transition frequencies" -- the authors noted that results could fluctuate greatly at times. 

During "plus" transition periods, however, Fama and French concluded that M&A wound up contributing more than 3% a year to the excess returns of value portfolios than to growth stock portfolios they studied. They added: "The impact is particularly large for the spread between small value and small growth returns." 

Given growth's oversized gains as markets rebounded in subsequent years following the Great Recession, a natural question IFA's investment committee has considered is whether any pickup in M&A activity has contributed to value's relative performance? This is a concern we typically hear from investors after economic conditions coalesce to make swallowing rivals whole a popular corporate growth strategy. 

In order to examine migration behavior of stocks across value and growth styles, we've worked with researchers at Dimensional Fund Advisors to tap into their resources. Using data compiled by the Center for Research in Securities Prices (aka CRSP), DFA's analysts sorted stocks into value and growth based on median price-to-book (P/B) ratios for each group. 

Dimensional also looked for us at median P/B valuations every year over an extended 55-year period. This analysis looked at percentages of stocks that remained within their respective style groups from one year to the next.  

In such a "non-migration" breakdown, the average portion of firms remaining in value and growth during a shorter time frame (June 2008-June 2018) didn't change much on a percentage basis from a longer period of review (June 1963-June 2018). The difference in average annual non-migration rates between this 10-year period studied and the 55-year period was less than a percentage point (0.9) for growth and 1.4 percentage points for value stocks. 

Of note, such similarities were observed during a period encompassing the tail end of a global financial crisis and subsequent historic rally in stocks. This suggests that 2008's Great Recession might've been too short of a timeframe -- or, any resulting pickup in M&A activity was too uneven -- to spur what Fama and French would characterize as a "plus" transition period between value and growth stocks. 

DFA's analysts also pointed out to us that other research they've conducted on this topic spanning even longer time frames shows that migration activity can vary greatly from one period to the next. In other words, migration trends of any significance aren't predictable in advance for short-term investment purposes. 

We should also interject here that such an analysis was based on data available to DFA researchers at the time of IFA's outreach to them and made available to our advisors only for illustrative purposes. That is, these results weren't intended to be presented to our clients as a basis to conduct trades or form any short-term investment strategy. 

Another caveat: Although our efforts to track style migration isn't intended to develop a near-term trading or asset allocation thesis, IFA's investment committee realizes that investors might try to associate any recent swings in return spreads between value and growth stocks. This is a question our wealth managers have fielded in the past, especially after stocks rallied strongly from 2008's global financial crisis. 

In the graph below, we can see through June 2019 that growth equities benefited during a rolling 10-year period studied following the Great Recession. IFA's portfolio analysts used data for the Fama/French U.S. Value Research Index and the Fama/French U.S. Growth Research Index. 

From July 2009 through June 2019, this value index lagged its growth counterpart on an annualized return basis by more than three percentage points (12.93% vs. 16.32%). It's probably also worth noting that such underperformance came with slightly higher standard deviation, which is a mathematical calculation used to measure how much risk is taken by investors at any given time. In these 10 years reviewed, the value benchmark had annualized standard deviation of 16.57% while its growth cousin produced 12.84%.

Despite such a rather disappointing stretch from a risk-adjusted performance perspective, prevailing academic evidence reviewed by IFA warns our portfolio managers against trying to time swings between value and growth. One research project that impresses us for its depth and scope was undertaken by James Davis, a Dimensional analyst. Although first published in late 2014, its overarching conclusions still generally seem to ring true today.3

Davis examined timing strategies that switch between value and growth stocks based on the past performance of any so-called value premium. In short, his extensive study found little evidence that these timing efforts added value as compared to buy-and-hold strategies focusing on value stocks. 

This research, along with studies by DFA's Wei Dai in 2016 ("Premium Timing with Valuation Ratios")4 and Brad Steiman in 2019 ("Perspectives on Premiums")5 lend even more credence to our view of the futility of trying to make investment decisions based on current gyrations in the value premium. 

Another red flag is raised by such a body of evidence. From Fama and French to Davis and Dai, those investigating value and growth styled stocks have noted that premiums can turn relatively quickly. As an example, see the graphic below showing changes at different times in premiums for value-focused investors over 10- and three-year periods. It also uses domestic Fama/French benchmarks and covers a large enough data set (1936 through 2018) to provide a bigger picture view of value versus growth. 

At IFA, we prize research that applies an intellectually rigorous and consistent means of evaluation covering the longest sets of data possible. The wealth of academic and professional evidence our investment committee has most confidence in provides our advisors with a clear takeaway: Trying to apply current return spreads and valuation ratios between different styled stocks isn't a very informative -- let alone reliable -- method to base asset-allocation decisions on when managing a globally diversified portfolio of index funds. 


Footnotes:

  1. Eugene Fama, "The Cross-Section of Expected Stock Returns," (with Kenneth R. French), Journal of Finance, 47 (June 1992). 
  2. Eugene Fama, "Migration,"(with Kenneth R. French), Financial Analysts Journal, (May/June 2007).
  3. James Davis, "Mean Reversion in the Dimensions of Expected Stock Returns," Dimensional Fund Advisors, November 2014. 
  4. Wei Dai, "Premium Timing with Valuation Ratios," Dimensional Fund Advisors, September 2016.
  5. Brad Steiman, "Perspectives on Premiums," (with Wei Dai), Dimensional Fund Advisors, March 2019.                                                       

This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There are no guarantees investment strategies will be successful. Investing involves risks, including possible loss of principal.