Moving beyond a narrow definition of value investing
Abstract: This study shows that the information content of valuation ratios can be highly dissimilar. It presents a value measure that outperforms book-to-market not only in terms of the abnormal returns a zero-cost portfolio formed on this sorting variable generates relative to factor models, but also in terms of its ability to capture firms with a high level of profitability and a strong profitability persistence. In addition, portfolios double sorted on profitability and value are used to move beyond the traditional definition of value investing. Long-only portfolios formed on profitability and book-to-market, however, do not help in separating winners from losers among value stocks. Instead, they rather predispose investors to firms with temporarily inflated accounting numbers. The abnormal returns that zero-cost portfolios double sorted on profitability and book-to-market generate relative to a Fama and French (2015) five-factor model are overwhelmingly due to the model's failure to price the lowest quintile portfolios. On the other hand, factor models face similar problems in pricing long-only portfolios formed on the basis of profitability and enterprise-value-deflated cash-based operating profitability. These portfolios consistently generate positive abnormal returns relative to the considered factor models. The results are difficult to reconcile with explanations based on the value premium as the corresponding portfolio firms resemble growth stocks in terms of both characteristics and covariances. These firms exhibit a high level of profitability and a strong profitability persistence after portfolio formation.
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