Multifactor Asset Pricing Analysis of International Value Investment Strategies

Abstract

Using a large international equity market database that has not been previously used for such a purpose, this paper documents that value (i.e., high book-to-market ) stocks outperform growth (i.e., low book-to-market ) stocks, on average, in most countries during the January 1975 December 1995 period, both absolutely and after adjusting for risk. The international evidence confirms the findings of previous work reported for the U.S.. For 1975-1995, the annual difference between the average returns on portfolios of high and low book-to-market stocks is 12.94% in North America, 10.42% in Europe, 17.26% in Pacific-Rim per year, and value stocks outperform growth stocks in 17 out of 18 national capital markets. Our analysis also shows that a three-factor model explains most of the cross-sectional variation in average returns on industry portfolios across countries and that the superior performance of the value investing strategy, documented in this study, is a manifestation of size and book-to-market effects. These results are consistent with those reported by Fama and French (1994, 1996) that show that the value-growth pattern in stock returns is largely explained by a three-factor asset pricing model. Our results suggest that the Fama and French (1996) three-factor asset pricing model is not limited to the U.S. stock market. Several recent studies have documented that value strategies (i.e., investing in stocks that have low prices relative to earnings, dividends, historical prices, book assets, or other measures of value) produce higher returns. Among these studies are Basu (1977), Rosenberg, Reid, and Lanstein (1985), De Bondt and Thaler (1985, 1987), Jaffe, Keim, and Westerfield (1989), Chan, Hamao, and Lakonishok (1991), Fama and French (1992), and Lakonishok, Shleifer, and Vishny (1994), all of which show that stocks with high earnings/price ratios or high book-to-market values of equity earn higher returns. A number of alternative explanations for the observed superior returns of value strategies exist. Fama and French (1992, 1993) argue that value strategies are fundamentally riskier and therefore the higher average returns associated with high book-to-market stocks reflect compensation for bearing this risk. A similar argument has been made by Chan (1988) and Ball and Kothari (1989). They suggest that the market overreaction (i.e., winner-loser effect) result of De Bondt and Thaler (1985) is due almost entirely to intertemporal changes in risks and expected returns. Lakonishok, Shleifer, and Vishny (1994), however, argue that value strategies yield higher returns because investors are able to identify mispriced stocks and not because they are fundamentally riskier. Ball, Kothari and Shanken (1995) report that the profitability of the value investing strategy is driven by performance measurement problems and microstructure effects. Kothari, Shanken and Sloan (1995) attribute the superior performance of value strategies to the research design and database used to conduct these studies [i.e., survivorship bias (see Davis (1994)], look-ahead bias [see Banz and Breen (1986)] and data snooping [see Lo and MacKinlay (1990)] in the selection of firms that are included in the CRSP and Compustat databases. Chan, Jagadeesh and Lakonishok (1995) show that this is not the case. Davis (1994) reports a value premium in U.S.stock returns prior to 1963 as well. In a recent study, Fama and French (1996) document that the superior performance of the value investing strategy is a manifestation of size and book-to-market effects. Empirical work has 3 discovered some stylized facts on the behavior of stock prices that cannot be explained by the capital asset pricing model (CAPM) of Sharpe (1964) and Lintner (1965). However, this evidence is largely based on firms in the U.S., and it is not at all clear how these facts relate to different countries. Without testing the robustness of these findings outside the environment in which they were found, it is hard to determine whether these empirical regularities are merely spurious correlations that may not be confirmed across capital markets. This study fills this gap in the literature. In addition, we document for the first time the cross-sectional relationship between beta, size (SMB), book-to-market (HML) and average industry portfolio returns in a sample of 2,629 stocks in 18 equity markets ( including the U.S.) over the 1975-1995 period. The first objective of this article is to examine the robustness of the value-investing strategy using monthly data for 18 equity markets and four regions of the world economy (i.e., North America, Europe, Pacific Basin and International) obtained from the Independence International Associates, Inc.(IIA) database for the 1975-1995 period. We note that in this study the term “international” refers to both the U.S. and non-U.S. stock markets. There are 1,554-2,629 stocks in this database that are tracked by Morgan Stanley Capital International (MSCI) throughout this period. For each country there is a set of five portfolio returns: market, value, growth, small and large. The sample covers more than 75 percent of each country’s market capitalization. There is no survivorship bias in the data set ( as defined by the MSCI database ) since each portfolio is calculated based on the companies that were actually in the MSCI database as of the Januaryrebalance date of each year. The use of such a broad international data set provides a unique opportunity for this analysis. By focusing on the 1975 to 1995 period, this paper studies the behavior of stock returns across countries using a large and updated database that has not been previously used for such a 4 purpose. To the extent that other countries are similar to the U.S., they provide an independent sample to reproduce the regularities found in the U.S. and compare the results to those reported in earlier studies . To the extent that our sample contains countries that are not similar to the U.S., it will increase our ability to shed additional light and help us understand the forces behind the superiority of value strategies. The second objective of the article is to investigate whether value stocks are riskier than growth stocks, since this issue remains controversial among researchers. We focus on betas, coefficients of variation and Sharpe ratios for value and growth strategies. Consistent with the empirical findings of Lakonishok, Shleifer, and Vishny (1994), our analysis provides evidence in support of (i) the superior performance of the value-investing strategy and (ii) the view that such strategies are not fundamentally riskier in 18 equity markets. However, this pattern in international stock returns cannot rule out the possibility that the superior performance of the value-investing strategy is a manifestation of size and book-to-market effects, as reported for the U.S. by Fama and French (1996). The third objective of this study is to examine whether the superior performance of valueinvesting in 18 capital markes is a CAPM related anomaly as argued by Fama and French (1996). This issue is addressed by implementing the Fama and French (1996) three-factor model internationally. However, our empirical investigation is based on portfolios that allow the slopes of the factors to vary over time as opposed to forming portfolios on size, book-to-market and other measures of value that result in factor loadings that are essentially non-time varying [ see Fama and French (1996 ) ]. Our evidence shows that the three-factor model explains most of the cross-sectional variation in average returns on industry portfolios across countries, and that the superior performance 5 of value investing documented in eighteen stock markets ( including the U.S.) is driven by relative size (SMB ) and distress (HML ) effects. Our results are consistent with those found for the U.S. by Fama (1994) and Fama and French (1996). Furthermore, the stock market evidence from around the world suggests that the Fama and French (1996) multi factor asset pricing model is not limited to the U.S. capital market. It holds across capital markets and regions of the world, although it does not uniformly explain portfolio returns in all markets. The rest of the paper is organized as follows. Section I describes the data used in this study. Section II presents annualized return spreads for value and growth strategies based on value and growth portfolios formed on an annual basis for three different investment horizons. Section III examines whether the superior performance of value stocks is related to the upward movements in stock markets. Section IV investigates whether the arbitrage portfolio formed by buying value stocks and selling growth stocks is associated with the effects of firm size. Section V analyzes the robustness of value investing strategies using the Fama and French (1996) three-factor asset pricing framework, and Section VI concludes the paper.