Redefining Value: Unveiling the Superiority of Intra-industry Value Factors

Abstract

This paper presents important insights into the superior performance of intra-industry value factors in forecasting average stock returns and enhancing portfolio performance. It advocates for a redefined understanding of the value premium decoupled from all industry-related risks and centred on intra-industry perspectives of value. The study is based on the US stock market from 1986 to 2023, utilising four separate value metrics: book-to-market, earnings-to-price, sales-to-enterprise value, and free cash flow-to-market equity, as well as a composite value factor. The study uses the Global Industry Classification Standard (GICS) to construct value factors within each industry. It further demonstrates that the combined intra-industry value factor exhibits superior Sharpe ratios, reaching up to 0.810 for the intra-industry composite value factor, compared to a Sharpe ratio of 0.356 for the normal composite value factor. Thus, by implementing intra-industry value strategies, investors may achieve more efficient portfolios, and likewise, the intra-industry value factors generate more accurate benchmarking of practitioners employing these strategies. In contrast to prior academic studies on intra-industry value factors, this paper establishes that this superior performance is attributed both to reduced risk and increased expected returns. The improved risk component, the study shows, comes from eliminating the industry-specific tail risk of industry exposures and systematically higher correlations among stocks within the same industries. The increase in expected return, on the other hand, is not easily explained by prior risk-based explanations for the normal value premium. Neither macroeconomic risk factors, financial leverage, nor a combination of several risk factors of operational leverage, investment, profitability, and duration-based risks can fully explain the intra-industry value premium. Even alternative intra-industry versions of these risk factors fail to capture the full breadth of the intra-industry value premium. Therefore, the study calls for further exploration into why this redefined intra-industry value premium is larger than the normal value premium.