Motivation What is the threefactor model (3FM)? Javier Estrada A - PDF document

Risk Revisited (II): The Three ‐ Factor Model Javier Estrada ADFIN – Winter/2014 1. Motivation • Why is this relevant for practitioners? • The size and value effects 2. Risk and Return • The CAPM • Factor models • The three‐factor model 3. The Big Picture Motivation  What is the three‐factor model (3FM)? Javier Estrada  A model to estimate the required return on assets IESE Business • Basically equity and equity funds School  It can be thought of as the CAPM plus two terms Barcelona Spain • A term to account for the size effect • A term to account for the value effect  Hence required returns are driven by exposure to … • the equity market, as opposed to the bond market • small ‐ cap stocks, as opposed to large‐cap stocks • value stocks, as opposed to growth stocks  Relative to the CAPM, its estimation requires … • a bit more information • a multiple regression ADFIN Winter/2014 1

Motivation  Why is the 3FM relevant for practitioners? Javier Estrada  Corporate Finance applications IESE Business • Estimation of the required return on equity School • Input in the WACC, which in turn is an input in … Barcelona Spain  project evaluation (NPV/IRR)  company valuation (DCF‐WACC model)  capital structure optimization (Min WACC) … • This is all about making proper corporate decisions  Portfolio Management applications • Estimation of the required return on funds  Accounting for the impact of the size and value effects • Used in the estimation of risk‐adjusted return  Proper ranking and evaluation of portfolio managers • This is all about evaluating performance properly ADFIN Winter/2014 The Size & Value Effects  A couple of important things to keep in mind Javier Estrada  The focus of the discussion will be … IESE Business • today on the model’s intuition and implementation School • in App3 on the CF applications Barcelona Spain • in the discussion of App3 on the PM applications  There are basically three pervasive and global patterns in Finance: In the medium/long term … • stocks outperform bonds • small‐cap stocks outperform large‐cap stocks • value stocks outperform growth stocks  As much as these return differentials are widely accepted, why they are observed is controversial • Some argue in favor of risk‐based explanations • Some argue in favor of ‘market inefficiencies’ ADFIN Winter/2014 2

The Size & Value Effects  Definitions Javier Estrada  Importantly, all definitions are relative and dynamic IESE Business • Relative: Based on a ranking School • Dynamic: They change over time Barcelona Spain  What is a small‐cap stock? • A stock with a ‘small’ market capitalization  This obviously depends on the country/sector  What is a value stock? • A ‘cheap’ stock relative to fundamentals  Low multiple (P/E, P/B, P/CF, …)  The two critical things to keep in mind about this • A company may change its classification over time Go • You can rely on fund providers for the classification Go ADFIN Winter/2014 The Size & Value Effects  Evidence: Return Javier Estrada  At this point it is largely beyond discussion that in IESE Business the medium/long term small‐caps outperform School large‐caps and value outperforms growth Barcelona Go Spain  Evidence: Risk  Here the issue is far more controversial • (Behavioral) Market inefficiencies (Imply a free lunch)  Investors overpay for the ‘safety’ of large/growth stocks and underpay for the ‘dangers’ of small/value stocks Go • Risk differentials (Imply there is no free lunch)  Small caps are more volatile, less liquid, less diversified, less able to withstand downturns, … than large caps  Value is largely a bet against the market  This is the view implicit in the 3FM ADFIN Winter/2014 3

Approaches  There are basically three approaches to estimate Javier Estrada required returns IESE Business  The CAPM (The standard) School  The 3FM (The main competitor) Barcelona Spain  Factor models (Many versions)  The CAPM  You know  Factor models  They include ‘whatever’ may help to explain, hence predict, returns • Theory takes a back seat  Not trivial to implement (not estimated in house) • Some examples Go ADFIN Winter/2014 The 3FM Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 4

The 3FM Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 The 3FM – Implementation  The CAPM Javier Estrada  R i = R f + MRP⋅ β i IESE Business • Current R f School • Long ‐term historical MRP Barcelona Spain • Medium ‐term historical β i  The 3FM S + HML ⋅ β i  R i = R f + MRP⋅ β i + SMB ⋅ β i V • Current R f • Long ‐term historical MRP, SMB, and HML • Medium ‐term historical β i , β i S , and β i V  In short, relative to the CAPM we need …  Data on two more explanatory variables  A regression with two more variables ADFIN Winter/2014 5

The 3FM – Implications R = R f + MRP · β + SMB · β S + HML · β V Javier Estrada IESE Business School Exposure to Exposure to Exposure to Barcelona Spain the market small ‐ caps value stocks  What does the 3FM imply?  Higher exposures to the equity market, to small caps, and to value stocks imply higher risk and therefore required returns should increase • Corporate Finance  This translates into an increase in the discount rate • Portfolio Management  This translates into an increase in the return required to ADFIN fund managers Winter/2014 The 3FM & and the CAPM  So, what does all this mean for the CAPM? Javier Estrada  Is beta useful? Is it alive and well? Is it dead? Should IESE Business the CAPM be used? Should it be discarded? School • Two approaches Barcelona Spain  Fight over the econometrics / Focus on the big picture  The big picture  Just look around • The CAPM is still widely used in CF applications • The 3FM is far more widely used in PM applications  McKinsey’s view (on the CF side) Go  Three final thoughts  Why are these premiums not arbitraged away? Go  A couple of interesting facts Go ADFIN  Think of the 3FM as just another tool in your toolbox Winter/2014 6

Appendix Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Evidence – USA Javier Estrada Small caps: $100 → $3,045,770 Large caps: $100 → $631,813 IESE Business School Value: $100 → $4,555,683 Growth: $100 → $347,063 Barcelona Spain ADFIN Winter/2014 7

Evidence – DMs Javier Small caps: $100 → $747 Estrada Large caps: $100 → $635 IESE Business School Value: $100 → $1,162 Growth: $100 → $376 Barcelona Spain ADFIN Winter/2014 Back Definitions Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Back 8

Definitions Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Back Behavioral Explanations Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Back 9

Factor Models Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Factor Models Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Back 10

McKinsey – ‘Valuation’ Book Javier Estrada Is Beta Dead? Criticism of the CAPM IESE Business School “What’s the bottom line? It Barcelona Spain takes a better theory to kill an existing theory, and we have not seen the better theory yet. Therefore, we continue to use the CAPM …, being wary of all the problems with estimating it.” ADFIN Winter/2014 Back Arbitrage v . Patience Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Back 11

‘Smart’ Investing Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 The Norges Fund Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Back 12