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What Exactly Is the Value Premium?

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.

Economic Factors The study "Monetary Policy and the Cross-Section of Expected Returns" examined the relationship between economic-cycle risk and the size and value effects. The authors used monetary policy as the variable determining economic-cycle risk. They found that:
  • There was a significant value premium in expansionary periods.
  • The premium was smaller in restrictive periods, but still statistically significant.
The authors also noted that since value firms are typically highly leveraged, they couldn't access capital as easily during periods of restrictive monetary policy. Thus, value firms were more susceptible to distress in times of restrictive monetary policy (weak economy).

The study "A Consumption-Based Explanation of Expected Returns" found that value (and small-cap) stocks delivered low returns during recessions, when the marginal utility of consumption was highest. In other words, the returns of value (and small-cap) stocks were more procyclical than growth (and large-cap). Thus investors had to be rewarded with high expected returns to hold these risky stocks.

And finally, consider the study "The Value Premium and Economic Activity." The authors examined the relationship between the value premium and macroeconomic variables such as industrial production, inflation, money supply and interest rates. The following is a summary of their findings.

First, in an economic expansion when industrial production rises, value stocks became less risky relative to growth stocks. Thus, the price of value stocks increased more than growth stocks. The results were that the spread between high book-to-market and low book-to-market stocks narrowed and the value premium declined.

In bad times, value stocks became more risky relative to growth stocks. Thus, the price of value stocks decreased faster than growth stocks, and the value premium increased. Therefore, there was a negative relationship between the value premium and industrial production.

The authors noted that the fact that there was a high value premium when industrial production was down isn't necessarily good news. It's just a sign of increased risk.

A similar relationship existed between the value premium and the money supply. Following an increase in the money supply, stock prices increased. The price of value stocks tended to increase more than the price of growth stocks, and the value premium shrunk. When money supply decreased, stock prices decreased with value stocks decreasing more than growth stocks, and the value premium increased. Therefore, there was a negative relationship between the money supply and the value premium.

Third, there was a positive relationship between the value premium and interest rates. As long-run interest rates rose, stocks became less attractive than bonds, stock prices decreased, and the price of value stocks decreased faster than the price of growth stocks. That led to an increasing value premium. When interest rates fell, the price of value stocks increased faster than the price of growth stocks, which led to a decreasing value premium. Thus, there was a positive relationship between interest rates and the value premium.

Overall, the authors found that value stocks were more sensitive to bad economic news. We see evidence of this in the data. From 1927 through 2010, during periods of economic expansion, the median value premium was 0.32 percent a month (with a mean of 0.46 percent). During recessions, the median premium was -0.31 percent a month (with a mean of 0.13 percent).

Given the large body of evidence, it seems hard to conclude that the value premium is solely the result of behavioral mistakes that lead to the persistent mispricing of value stocks. The implication is that the value premium isn't a free lunch.

Photo courtesy of paparutzi on Flickr.
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