Why Academic Evidence Shouldn't Be Taken at Face Value

There's a large body of academic research demonstrating that value stocks (e.g., low price-to earnings stocks) produced higher average returns than growth stocks (e.g., high price-to-earnings stocks). However, it's important to consider the quality of the evidence before incorporating it while building your portfolio. The following is an example of why you should take a deeper look at evidence supporting your investing beliefs to ensure it's sound.

The author of the paper, "Do Value Investors Add Value?," sought to determine not only if the value premium exists in Canada, but whether "sophisticated" value investors add value beyond that of a naive screening process (sorting by price-to-earnings or book-to-market).

The author found that a strong and pervasive value premium exists in Canada over the sample period, one that persists in a bull market and bear market and also during a recession/recovery. Furthermore, he found that value investors do add value, in the sense that their process of selecting truly undervalued stocks via in-depth security valuation produces significantly positive excess returns over and above a naive approach of simply selecting low price-to-earnings or low price-to-book stocks.

However, there are several issues with the paper that should be addressed:

• The paper suffers from a severe small sample problem. The naive value portfolio contains an average of about just 10 stocks. The sophisticated value portfolio averages about just three stocks, and there are some years when it contains just one single stock. No institutional investor or mutual fund could manage money with such concentrated positions.
• The sample is dominated by tiny stocks. The average market cap of the sophisticated value portfolio drops below $24 million at one point, and it's below $70 million for much of the sample.
• Just to make the effect of tiny stocks even more severe, the author uses equally-weighted returns.
• There's no control for differences in tilts between the naive and sophisticated portfolios. The sophisticated portfolio may have a different degree of value tilt, which could explain the differences in returns.
• Even with all these problems, the paper's findings weren't statistically significant, meaning the paper doesn't report a reliable return difference.

And finally, it's often a long way from theoretical strategies to realizable results. (Often costs can account for, or even exceed, the benefits of a theoretical strategy.) In this case, there are at least two major issues:

• The lack of diversification (which would make it impossible for any institutional investor or mutual fund to benefit from such a strategy)
• The tiny size of the stocks in the sophisticated portfolio (which would create implementation problems in terms of trading costs)

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