There's a large body of evidence that value stocks have outperformed growth stocks. The evidence is persistent and pervasive both around the globe and across asset classes. While there's no debate about the premium, there are two competing theories for its existence.
The first of the two theories claims that value stocks are the stocks of riskier companies - their prices co-move with some risk factor, be it distress, liquidity or "Black Swan" risk (the risk of an extreme event). Professors Eugene Fama and Ken French constructed a proxy for this risk factor - the HmL factor (the return of stocks with high book-to-market values minus the return of stocks with low book-to-market values) - that can be used to assess a stock's sensitivity to this yet-to-be-identified source of risk in the economy. Value stocks have high HmL loadings and, therefore, are expected to deliver high average returns as risk compensation.
On the other hand, behaviorists believe the premium results from pricing mistakes - investors persistently overprice growth stocks and underprice value stocks. Behaviorists point out that while it may be that some risk factors are priced, the return premia associated with these factor portfolios are simply too large, and their covariance with macroeconomic factors are just too low (and in some cases negative) to be considered compensation for systematic risk.
The debate between the competing explanations is not only important in determining whether the value premium is compensation for risk (in which case a risk averse investor might wish to avoid the incremental risks) or a "free lunch" (in which case all investors would benefit from exposure to it), but if the risk-based theory is correct, value stocks should be selected according to their loadings on the HmL factor. On the other hand, if the mispricing theory is correct, value stocks should be selected according to their ranking in terms of book-to-market, or other valuation ratios such as cash flow-to-market value or earnings-to-market value.
The authors of the 2012 paper "What Drives the Value Effect? Risk versus Mispricing: Evidence from International Markets," contribute to the literature by testing whether the cross-section of expected returns is better explained by value characteristics (such as measures as BtM) or by loadings on the HmL factor. To help understand the issue, consider the following example.
Consider a company with a relatively low market capitalization. This small company happens to be a parts supplier. Their only customers are General Motors (GM), Ford (F), General Electric (GE), and Boeing (BA). Its "characteristic" by market capitalization says it's a small company. However, it's likely that it would have a negative loading on the size factor because its business is entirely dependent on the performance of large companies, not small companies. In other words, while it's a small company, the performance of its stock price would co-vary with that of large companies, not small ones. In terms of the study, the authors were testing to see if what matters more was the covariance (the loading factor) or the characteristics (the valuation metrics themselves).
Their study, which used 30 years of data from 23 developed countries and U.S. data from 1972, sorted stocks first on characteristics and then on factor loadings. They then reversed the process. They concluded that while the value premium may be generated in part by risk factor exposure, mispricing plays a larger and more significant role. "The results for portfolios sorted on factor loadings and characteristics strongly favor the mispricing theory over the risk-based theory." Specifically, they found that "after controlling for the BtM characteristic, HmL loading explains only a small fraction of the cross-section of expected returns. On the other hand, after controlling for HmL loading, BtM characteristic still remains the most important variable for explaining the cross-section of expected returns."
Given the importance of these findings, before concluding I thought it worthwhile to do a brief review of some of the literature on the risk story - to make sure that you don't entirely dismiss the risk story.
Is the Value Premium a Free Lunch?
We begin with a study, "Risk and Return of Value Stocks," by Nai-fu Chen and Feng Zhang. The authors found that there are three very common characteristics of value stocks that all have simple intuitive risk interpretations: high volatility of dividends, high ratio of debt to equity, and 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 are present, returns are greater.
Next we look at the study, "The Value Premium," by Lu Zhang. He concluded that the value premium could be explained by the asymmetric risk of value stocks -value stocks are much riskier in bad times and only moderately less risky in good times. Zhang explains that the asymmetric risk of value companies exists because value stocks are typically companies with unproductive capital. Asymmetric risk is important because:
- Investment is irreversible - once production capacity is put in place, it is very hard to reduce. Value companies carry more nonproductive capacity than do growth companies.
- In periods of low economic activity, companies with nonproductive capacity (value companies) suffer greater negative volatility in earnings because the burden of non-productive capacity increases and they find it more difficult to adjust capacity than do growth companies.
- In periods of high economic activity, the previously nonproductive assets of value companies become productive while growth companies find it harder to increase capacity.
- In good times, capital stock is easily expanded, while in bad times adjusting the level of capital is an extremely difficult task and is especially so for value companies.
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.
The study by Gerald R. Jensen and Jeffrey M. Mercer, "Monetary Policy and the Cross-Section of Expected Returns," examined the relationship between economic-cycle risk and the size, as well as the value, effect. The authors used monetary policy as the variable determining economic-cycle risk. They found that:
- There is a significant value premium in expansionary periods.
- The premium is smaller in restrictive periods, but it is still statistically significant.
The authors also noted that since value firms are typically highly leveraged, they are more negatively impacted in their ability to access capital during periods of restrictive monetary policy. Thus, value firms are more susceptible to distress in times of restrictive monetary policy (weak economy).
The study, "A Consumption-Based Explanation of Expected Returns," by Motohiro Yogo, found that value (and small) stocks deliver low returns during recessions, when the marginal utility of consumption is highest. In other words, the returns of value (and small) stocks are more pro-cyclical than growth (and large). Thus, investors must be rewarded with high expected returns to hold these risky stocks.
And finally, we review the findings of the study "The Value Premium and Economic Activity: Long-run Evidence from the United States," by Angela J. Black, Bin Mao and David G. McMillan. They examined the relationship between the value premium and macroeconomic variables such as industrial production, inflation, money supply and interest rates. The study covered the period 1959-2005. The following is a summary of their findings.
First, in an economic expansion when industrial production rises, value stocks become less risky relative to growth stocks. Thus, the price of value stocks increase more than growth stocks. The result is that the spread between the high book-to-market and low book-to-market stocks narrows and the value premium declines. In the bad times, value stocks become more risky relative to growth stocks. The result is that the price of value stocks decreases faster than growth stocks, and the value premium increases. Therefore, there is a negative relationship between the value premium and industrial production.
Second, a similar relationship exists between the value premium and the money supply. Following an increase in the money supply, stock prices increase. The price of value stocks tends to increase more than growth stocks and the value premium shrinks. When money supply decreases, stock prices decrease, with value stocks decreasing more than growth stocks, and the value premium increases. Therefore, there is a negative relationship between the money supply and the value premium.
Third, there is a positive relationship between the value premium and interest rates. As long-run interest rates rise, stocks become less attractive than bonds and stock prices decrease and the price of value stocks decrease faster than the price of growth stocks. That leads to an increasing value premium. When interest rates fall, the price of value stocks increases faster than the price of growth stocks. This leads to a decreasing value premium. Thus, there is a positive relationship between interest rates and the value premium.
Given this large body of evidence, it seems hard to draw the conclusion that the value premium is solely the result of behavioral mistakes that lead to persistent mispricing. In other words, it seems likely that at least part of the premium can be attributed to some type of economic risk. The implication is that the value premium is not a free lunch. However, the evidence does suggest that it's at least a free stop at the dessert tray, and perhaps even a free entrée. Thus, you may want to consider adding more value exposure to your portfolio.