Aiming High
Three Morningstar researchers, along with Yale’s Roger Ibbotson, have penned what may safely be called this company’s most ambitious article. All right--book.
The central tenet of the Popularity Asset Pricing Model, or PAPM, as the authors call their creation, is that risk doesn’t fully explain stock market behavior. With some modest exceptions, previous models presume that higher return comes from assuming greater peril. Not so, argue PAPM's authors. Securities come with various attributes, many of which are preferences rather than sources of additional risk.
Cost-Benefit Analysis
That claim unquestionably is correct. Consider, first, securities that lie outside the stock market: municipal bonds. Risk analysis suggests that muni bonds’ expected returns, and thus their yields, should be higher than Treasuries, because muni bonds are less creditworthy. Yet the opposite is true. This is because of the tax advantage that accrues to municipal securities. That feature makes them more popular than they otherwise would be.
What applies to the fixed-income market also applies to equities. For those who invest in taxable accounts, stocks that pay no dividends are more attractive those with yields. If all accounts were taxable, stocks that lacked yields would be preferred to their rivals, as muni bonds are to Treasuries.
As it turns out, there is enough money in tax-sheltered equity accounts to neutralize this effect. There is no discernible premium paid for dividend-free stocks, as there is for municipal bonds. Thus, the authors do not list dividend policy among their equity popularity factors. But the example, I believe, is instructive. Previous stock market pricing models specified security drawbacks, which they called “risks.” The PAPM reverses that mindset by evaluating benefits.
Surfacing the Relationship
Popularity’s authors identify what stock investors seek. Not every investor, in every situation, but enough to affect how that security is priced. In exchange for receiving the benefit, the buyer concedes some portion of future return. That occurs because the stock’s popularity has increased its price. All things being equal, securities that cost more at the time of purchase will appreciate less.
Sometimes, investors recognize the nature of the arrangement. Stocks that trade readily are useful during down markets, when investors may need to raise cash. Intuitively, most investors understand than an exchange has been made. An illiquid security might have brought them somewhat greater profits, but at the cost of portfolio maneuverability. That is a deal they were willing to make.
On other occasions, however, investors may not realize the bargain that they have struck. For example, they may invest in companies that have prominent brands, strong competitive advantages, and sterling reputations on the belief that those make for better investments. Overall, though, such stocks tend to lag because of their popularity. Their perceived high quality makes them attractive--and therefore relatively expensive.
CAPM vs. PAPM
These are but examples. The point is that the decision to price stocks’ benefits, rather than their risks, is a break from the past. Because of this divergence, the implicit advice offered by the PAPM to investors differs from its predecessors. The contrast is particularly strong with the Capital Asset Pricing Model.
1) The Market Portfolio
Famously, the CAPM concludes that all investors should own the same equity portfolio: all stocks, weighted according to their market capitalizations. Conservative investors will combine the market portfolio with cash, while those who are aggressive will leverage. Either way, their stock positions are identical.
In contrast, the PAPM permits, practically speaking if not literally, an infinite amount of non-market portfolios. Risk, as defined by the CAPM, is universal. Preferences for popularity features are not. Your “efficient” portfolio will not match mine because our predilections differ.
2) Implementation
The CAPM counsels simplicity. Because all equity investors are to hold the entire market, there is no need to “optimize” the portfolio. Not only does one size fit all, but it also has been already specified.
The PAPM implies complexity. Implementing it in full requires measuring: 1) the investor’s popularity preferences, and 2) each stock’s score for each popularity factor, then 3) running a portfolio-optimization routine. You would not wish to attempt the computation in your head.
In practice, of course, the PAPM can--and surely would be--applied informally. By thinking through the PAPM framework, investors would acknowledge their preferences, explicitly. That exercise would give them the opportunity to improve their portfolios by discarding stocks that carry unnecessary popularity features. There’s no reason to own benefits that others prize if the investor does not.
3) Security Pricing
Under the CAPM, the expected excess return of a stock is directly proportional to its beta (that is, its sensitivity to stock market movements.)
With the PAPM, the stock’s expected excess return remains partially a function of its beta (as previously stated, the PAPM acknowledges that risk does have a role in equity pricing) but is supplemented by the effects of popularity features. Each investor’s preference rolls up to become the marketplace aggregate, weighted, of course, by the amount of assets employed. (Money talks.)
Upcoming
On Friday, we’ll see how the theory appears in practice. In addition to providing the intuition behind the PAPM and specifying it mathematically, the authors crunched a great deal of market data to identify several popularity features and to price the cost of their benefits. Friday’s column will summarize those findings.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.
