Migration

Researchers have tried to understand the origins of the value premium since the publication of Rosenberg, Reid, and Lanstein (1985). The driver of the premium, however, cannot be understood theoretically until there is a definitive mapping of exactly where the premium originates statistically in

the various BE/ME and size portfolios. Fama and French (2007) once again lead the community in addressing that question and provide a nice illumination of the changing size and BE/ME characteristics of individual stocks when viewed across annual periods of portfolio formation. This type of portfolio movement is described by Fama and French asmigration.

According to the authors, the migration of value stocks provides the largest economic impact on the value premium. While some of the impact on returns is generated by a few extremely distressed high BE/ME firms that are ultimately removed from the computation of portfolio returns, and by a few value companies that are acquired by other companies, most of the difference in returns is generated when value stocks subsequently earn high operating returns and are rewarded with higher market values. Mechanically, these successful value stocks migrate from high BE/ME portfolios toward larger size, lower BE/ME quintiles at the time of annual portfolio formation.

Next, Fama and French find that the value premium is also a function of poorer performance by the lowest BE/ME growth stocks that migrate to core size and BE/ME portfolios at the time of annual portfolio formation. However, the impact from growth stock migration is smaller than that from value stock migration. Value stocks that migrate contribute approximately 3.5% more per year to overall returns than growth stocks that migrate. However, migratory growth stocks that suffer deteriorating fundamentals generate a relative return disadvantage to similarly suffering value stocks by 5.1% per year for small cap stocks and a return disadvantage by 1.2% for large cap stocks.

Finally, Fama and French suggest that the value premium is also generated by growth and value stocks that do not change characteristics over time and thus do not migrate. However, the difference in performance is small for this group of non-migratory stocks. Small cap stocks that do not migrate contribute 1% per year to the value premium, while large stocks contribute 1.7%. The authors describe this contribution to the value premium asmodest.

Figure 4 provides a graphical illustration of data presented in Fama and French (2007).17_{The two} charts represent two ends of the size and valuation spectrum, i.e. big growth stocks and small value stocks. In Chart A, Fama and French observe returns for stocks that begin in the Big/Growth portfolio and then observe their average annual migration to various size and BE/ME portfolios. Results show that stocks migrating away from the Big/Growth portfolio to smaller ME characteristics typically generate large negative returns - as would be expected. Big/Growth stocks that do not migrate (87% of stocks) generate small, albeit positive, returns. The total average portfolio return for Big/Growth stocks over the entire sample period is a loss of almost 1% per year.

Chart B shows that approximately 31% of surviving Small/Value stocks (not defunct or acquired) migrate and change characteristics, a percentage significantly greater than their Big/Growth counterparts. While average annual returns for non-migrating Small/Value portfolio are also fractionally positive (0.40%), one-step migration as a function of changes to BE/ME from Small/Value to Small/Neutral is large (16% of stocks) and generates large positive annual returns (+19%). One-step migration as a function of changes to size from Small/Value to Big/Value is relatively small, only 5% of stocks in the original portfolio. However, this migration generates very large average annual returns (+53%). It is important for investment managers who analyse these results for potential exploitation to remember that Fama and French rebalance portfolios yearly; therefore, the same stocks are not likely responsible for generating returns of 166% per year for the few stocks (0.3%) migrating from the Small/Value to the Big/Growth portfolio.

Fama and French explain stock migration by saying that extreme portfolio size and BE/ME quintiles are simply bounded by operational reality. Again, higher distressed value companies, identified at the beginning of each statistical year, become defunct, acquired for a premium, or restructure and

FIGURE 4: Average annual returns of stocks migrating from Big/Growth and Small/Value portfolios. (percent market cap of migrating stocks in parenthesis)

Chart A

Migrating from Big/Growth Total Return = -0.9%

Chart B

Migrating from Small/Value Total Return = 9.2% -12% 53% (10%) -14% 61% (5%) BIG (0.2%) 166% (3%) BIG (0.3%) 0.8% (87%) -53% SMALL -39% (0.0%) 50% SMALL -36% 0.3% (1%) 19% (0.6%) (16%) 0.40% (69%)

GROWTH NEUTRAL VALUE GROWTH NEUTRAL VALUE

improve in type during subsequent annual observation periods. The status quo distress condition is largely untenable for such companies. Results are consistent with observations in Fama and French (1995) that growth stock earnings, relatively strong at portfolio formation, tend to migrate in the subsequent period to lower levels. Poor value stock earnings, observed at portfolio formation, tend to rebound in the subsequent return observation period. Again, behaviouralists would suggest investor surprise is responsible for the return premium and not risk differences.

Fama and French (2007) somewhat logically observe that negative migration of value stocks is (and would be) rare. There is simply nowhere to go for these stocks but up or out. Similarly, the least distressed growth companies that are identified at the beginning of each portfolio formation period have little room to improve; therefore, positive migration for these stocks is rare. There is nowhere to go for growth stocks but down or out.

Figure 5 illustrates what should be the typical bounded characteristics for the accounting book value statistic. The chart plots the relationship between all NYSE, AMEX, and NASDAQ stock returns and their price-to-book characteristics observed at January 2007. The usual BE/ME ratio has been flipped to ME/BE (or price-to-book) to better reflect the migratory relationship for conditions of negative book value. The distressed value condition (in this instance low P/B) is clearly bounded by zero since stocks rarely experience negative book values for any meaningful period of time.18 _{Growth stocks also have a} statistical P/B ceiling. For the month ending January 2007, few stocks trade at more than 10 times its fundamental value – a condition not likely to vary greatly over time.

Since 1992, the academic and investment community have debated the existence and origins of the value premium in US and global stock returns. The lineage of almost two decades of academic research has been dominated largely by two authors, Eugene Fama and Kenneth French. The research conversation over this period can best be characterised by a repeating cycle of three phases. First, Fama and French offer periodic advances in assessing the validity of the 3-factor model and its ability to successfully explain the cross section of average stock returns. Next, other researchers test potential problems with the model or attempt to advance the identification of the underlying risk (or behavioural condition) for which the individual factors proxy; and finally, Fama and French produce research rebuttals to successful challenges to their work. Unfortunately, the repeating cycle of the three phases has yet to conclusively identify why the value premium exists, whether it is a function of some

underlying common risk factor, or whether it is simply a un-arbitraged persistent return premium originating from investor over-reaction.