Last Updated Aug 31, 2011 4:27 PM EDT
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.
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
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.
- Recessions happened with far less frequency than good economic times.
- The longevity of recessions was far shorter than that of good times.
Photo courtesy of anathea on Flickr.
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