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Why Value Stocks Have Higher Expected Returns

Value stocks are the stocks of companies that have:

  • Low price-to-earnings ratios
  • Low price-to-book ratios
  • Low price-to-dividend ratios
  • Low price-to-sales-and-cash-flow ratios
In other words, their prices are depressed. The logical reason for the low prices is that value stocks are the stocks of riskier companies. To entice you to take incremental risks, their prices have to be depressed enough so you're compensated with sufficiently high expected returns. And value investors have been rewarded with a large risk premium. From 1927-2010, the value premium was 4.8 percent.

Academics have long debated the source of the value premium. Some believe it results from economic risks, while others believe it's more of a behavioral story -- investors persistently underestimate the power of the reversion to the mean of abnormal earnings growth. My own view is that while most of the premium is a result of economic risks, there's probably some truth to the behavioral story.

Research papers supporting the risk story have found that there are some simple and compelling reasons for the value premium. For example, value stocks are typically characterized by greater leverage and higher volatility of both earnings and dividends -- a risky combination.

Studies have also found that the returns of value stocks are more procyclical than the returns of growth stocks -- they're more risky than growth stocks in bad times (and less risky in good times, though to a lesser extent). Because investors are risk averse, they require a large premium to accept that risk.

Value companies also tend to be distressed, with high leverage and high uncertainty of cash flow. Therefore, shocks to the default spread (the spread between highly rated bonds and lower-rated credits) explain the cross-section of returns and is consistent with value being a measure of distress risk.

And finally, studies have found turnover is negatively correlated with returns -- low-turnover, less-liquid stocks have higher returns. This is consistent with a risk story. Investors demand higher returns as compensation for the incremental trading risks associated with low turnover stocks. And low turnover stocks display many characteristics commonly associated with value stocks.

More on MoneyWatch:
Does Russell Add Value? Does SEI Add Value? Why Scary Announcements Are Great for Your Portfolio TIPS Update for February 2011 Quest for Alpha: 10 Rules for Being a Successful Investor
Three ways I can help you become a wiser investor:

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