What Exactly Is the Value Premium?

Last Updated Aug 31, 2011 4:27 PM EDT

The existence of a value premium -- the difference in returns between high book-to-market stocks and low book-to-market stocks -- has been well documented. However, there's controversy as to its source. Some believe it's a risk story -- value stocks are the stocks of riskier companies. Behavioralists believe it results from pricing mistakes -- investors persistently overprice growth stocks and underprice value stocks.

There's sufficient evidence for both sides. In other words, while the value premium isn't a free lunch (value companies are riskier than growth companies), it might just be a free stop at the dessert tray (the premium may be too high to be fully explained by the incremental risks).

So you don't make the mistake of believing the value premium is a free lunch, we'll review of some of the literature.

Greater Risk We begin with the study "Risk and Return of Value Stocks." The authors found three common risk characteristics of value stocks:
  • High volatility of dividends
  • High ratio of debt to equity
  • High volatility of earnings
The three factors all capture the returns information (produced high correlations) contained in portfolios as ranked by book-to-market value. When these three factors were present, returns were greater. The authors concluded that value stocks were cheap because their companies tended to be firms in distress, with high leverage and substantial earnings risk. Thus, they provided higher returns due to the greater risks.

Next, we look at the study "The Value Premium," which concluded that the value premium could be explained by the asymmetric risk of value stocks. Value stocks were more risky than growth stocks in bad economic times, but less risky than growth stocks in good economic times. However, the size of the difference in risk was much lower in good times than in bad times. In other words, value stocks were much riskier in bad times and only moderately less risky in good times. The study's author explains that the asymmetric risk of value companies exists because value stocks are typically companies with unproductive capital:
  • Capital investment was irreversible. Once production capacity was put in place, it was very hard to reduce. Value companies carried more nonproductive capacity than growth companies.
  • In periods of low economic activity, companies with nonproductive capacity (value companies) suffered greater negative volatility in earnings, because the burden of non-productive capacity increased and value companies couldn't adjust as fast.
  • In periods of high economic activity, the previously nonproductive assets of value companies became productive while growth companies found it harder to increase capacity.
  • In good times, capital stock was easily expanded, while adjusting the level of capital was difficult in bad times, especially for value companies.
The author also observes that:
  • Recessions happened with far less frequency than good economic times.
  • The longevity of recessions was far shorter than that of good times.
When these facts are combined with a high aversion to risk by investors (especially when that risk can be expected to show up when their employment prospects are more likely to be in jeopardy), the result is a large and persistent value premium.

Photo courtesy of anathea on Flickr.
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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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