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The Value Premium: Risk Or Mispricing?

Larry Swedroe profile picture
Larry Swedroe

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

This article was written by

Larry Swedroe profile picture
Larry Swedroe is head of financial and economic research office for Buckingham Wealth Partners,  a Registered Investment Advisor firm in St. Louis, Mo.. Previously, Larry was vice chairman of Prudential Home Mortgage. Larry holds an MBA in finance and investment from NYU, and a bachelor’s degree in finance from Baruch College. To help inform investors about the passive investment approach, he was among the first authors to publish a book that explained passive investing in layman’s terms — The Only Guide to a Winning Investment Strategy You'll Ever Need (1998 and 2005). He has authored seven more books: What Wall Street Doesn't Want You to Know (2001), Rational Investing in Irrational Times (2002), The Successful Investor Today (2003), Wise Investing Made Simple (2007), Wise Investing Made Simpler (2010), The Quest for Alpha (2011), and Think, Act, and Invest Like Warren Buffett (2012). He also co-authored eight books: The Only Guide to a Winning Bond Strategy You’ll Ever Need (2006, with Joe Hempen), The Only Guide to Alternative Investments You’ll Ever Need (2008, with Jared Kizer) and The Only Guide You’ll Ever Need for the Right Financial Plan (2010, with Tiya Lim and Kevin Grogan), Investment Mistakes Even Smart Investors Make (2011, with RC Balaban), The Incredible Shrinking Alpha (2015 and 2020 with Andrew Berkin) Reducing the Risk of Black Swans (2013 and 2018 with Kevin Grogan), Your Complete Guide to a Successful and Secure Retirement (2018 and 2020 with Kevin Grogan), and Your Essential Guide to Sustainable Investing (2022 with Sam Adams). He writes for AdvisorPerspectives.com, AlphaArchitect.com, and TheEvidenceBasedInvestor.com. You can follow him on Twitter  (http://twitter.com/larryswedroe).

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Comments (24)

Eric Weisburg profile picture
Thanks for the informative and scholarly article. It has inspired me to download your latest book.
Larry Swedroe profile picture
Glad you found it helpful.

And hope you enjoy the book. I'm always happy to answer personal emails from readers of my books (and blog posts).

BTW-of all my books my personal favorite (one most proud of) is Wise Investing Made Simple

Best wishes
Larry Swedroe profile picture
That's the well known lottery effect in not only growth stocks but penny stocks, stocks in bankruptcy and IPOs. Investors love positive skewness and excess kurtosis (like lottery ticket distribution).

Best wishes
Thanks for all the data! My own (data-poor) theory has been that the pressure for short-term outperformance (on both individuals and fund managers) causes growth stocks to become chronically over-priced as these are the stocks perceived as most likely to be fast "four-baggers". When value stocks outperform, it is generally over a longer time period, thus they carry a very real risk- the risk of losing clients or your job (or at least your bragging rights) due to short- (and mid-) term underperformance.
Thank you for another great article.

With regard to momentum, I agree with the comment posted above that excessive pessimism is underrated as a factor. When I was inside a company (some years ago), it was my impression that our stockholders always overreacted to negative events, even those which were clearly of a temporary nature. Until the day arrives that a Fed Chairman gives it a catchy name (such as happened with "irrational exuberance") I believe it will continue to be underappreciated.
Larry Swedroe profile picture
Yes that is partly why MOM exists, also the slow reaction by investors is another. And then on the down side, you get negative momentum by forced sales like margin calls which push prices down and lead to more margin calls, and so on. And also investors getting pushed beyond their stop loss limits and finally investors getting pushed beyond their "breaking point" when they finally cave in. That leads to pushing more investors past it.
Can get same type thing on upset when have short squeeze.

stvrob_63 profile picture
Great Article. You have given me much to think about. I've generally subscribed to you "mispricing" (2nd theory) but I will have to give some closer thought to this. In my thinking, growth stocks are more likely to be mispriced because it is more difficult to value them correctly. To be honest, its quite impossible. So market pricing is much more likely to be controlled by sentiment, making them much riskier during periods of positive market sentiment (as their price climbs higher and higher above what can only be shown in retrospect to be far above correct valuation), During periods of negative sentiment, excessive pessimism drives them well below their correct valuation, so they are much less risky to purchase.
I suppose its not really this simple or I could have quit doing this sometime ago.
Bill Simoes profile picture
Larry; I enjoy your articles and thank you for doing all the hard work of reading and summarizing the literature.

I am a passive investor with a portfolio biased towards value and small cap. I am geographically diversified as well.

Do you think the momentum anomaly is worth exploiting?
Larry Swedroe profile picture
Mom persists, no doubt, but hard to exploit due to costs
so best way is to access it is to basically delay trades you would make otherwise. So hold winners bit longer (use buy and HOLD ranges, not just buy ranges) and avoid buying stocks that drop into the index or asset class until negative momentum ceases.

The funds we use do just that, Bridgeway and DFA
That's the simplest, easiest way to access
Best wishes

Bill Simoes profile picture
Thank you Larry.

With regards to profiting from the Momentum Anomaly. Just want to make sure I understand your response.

I will put a band around my portfolio allocations. For example if I hold 10% in US large value stocks, I would not buy until the allocation fell to 9% and not sell until the allocation reached 11%.

Have I got it right?
Larry Swedroe profile picture
That's the idea but I think that's too tight a band, will lead to too many trades, and for taxable accounts too much taxes
I suggest rule of 5/25 for each asset class,
So 5% absolute or 25% RELATIVE, whichever is triggered

So for major asset classes like stocks and bonds, it would be 5%. So if were 60/40 would not rebalance until 65 or 55 for stocks or 35/45 for bonds.

But for sub asset classes, say like EM where might have 10%, or 5% then absolute 5% too big, so 25% of the allocation, or if 10% target take 7.5 and 12.5

The exact level not as important as the DIscipline

One other suggestion if want to be more technically accurate, the more volatile the asset class the wider the band might be.

My book, The Only Guide to the Right Financial plan goes into detail on this and many other topics.
Hope that helps
Will more people investing in value funds and trading them make the market more efficient? Will that remove the value premium? Please let me know what you think!
Larry Swedroe profile picture
Value premium has been known for decades and it still persists

Certainly if it is related to risk than it should persist,

If it is behavioral mistake it can still persist if for no other reason than limits to arbitrage and governance rules against margins and shorting for institutional investors. and of course human behavior is hard to change. The lottery effect alone probably accounts for good part of value premium (over paying for growth stocks hoping to find the next Google

Hope that helps
Extending this idea a bit, I wonder about the efficiency of private equity "markets" vs. public equities. I think I could guess where many private equity folks would stand on this issue....
Larry Swedroe profile picture
I just wrote a piece to be published shortly on PE and the returns are below publicly available small value stocks, a reasonably similar risky benchmark, but without the liquidity risk and also you get daily pricing
and transparency
You can read my chapter in Only Guide to Alternative Investments or Quest for Alpha
Great article, its interesting to see how the literature on this issue is evolving. One thought comes to mind: it seems like there is consensus about p/b as the key value metric among scholars, but we all know that valuation is a slippery animal and several metrics are useful.

Given that value companies have higher levels of debt, they may not be any cheaper than other companies when we look at price to enterprise value. High levels of debt reduce the likelihood of buyouts or takeovers. This lack of "public-private market arbitrage" opportunities may cause investors to discount the price of a company's common stock because value can only be realized via price appreciation, buybacks and dividends. I know from my experience commenting on SA that many folks will give a company a premium if they think there is significant takeover risk, all else equal. Maybe this is similar to Buffet's "time arbitrage" idea because he doesn't seem to be as obsessed about "catalysts" as other market participants.
Larry Swedroe profile picture
Actually btm is used generally because it is the most stable value metric, not because it is best predictor or produces highest value premium

p/e and p/cf have higher value premiums. p/d the lowest, much lower

And in fact it appears that multiple screens adds more value than single screen as you gain a diversification benefit as the different metrics are not perfectly correlated

Best wishes
Larry Swedroe profile picture
retail investor
I don't agree with that. The exposures to the factors still explain almost all of the returns to diversified portfolios. And thus you have to adjust for say someone who invests in value stocks and not compare their returns to the S&P, but to a value index fund.
The research has looked at this the right way. See papers by Odean and Barber and they show how miserable individual investors have done and the people who are the most active do even worse!!!
The only issue is was the exposure to value factor mispricing or risk, not is it the right measure of performance. You're mixing the two issues

Hope that helps
Best wishes
An important take away from this movement to re-label 'risk-factors' as just 'factors' is the implications for all the research into active-vs-passive investing returns.

None of the research into retail investors' returns has measured and compared personal portfolio returns to benchmark indexes. They all measure individual positions owned and then DISCOUNT actual returns for the FF 'risk-premiums' ----- as if the actual returns don't matter because they came as a result of assuming more risk. See list items 7 and 9 at http://bit.ly/r8YeXu

But when you accept that the returns are NOT due to 'risk' then there is no excuse for discounting individuals' actual returns.
Larry Swedroe profile picture
Glad you enjoyed the article

Something for you to consider. The evidence is very clear that passively managed value funds have persistently outperformed actively managed ones, with virtually no evidence of any persistence by active managers in terms of outperformance beyond the randomly expected.

Given that evidence there is no need to check any of the company's or sectors prospects because the market has already done that for you---the prospects are in the price.

Example, the fund I personally use and my firm recommends for US SV allocation is BOSVX, and it's ranking ytd is 3 in terms of percentile by M*, thus the odds of outperforming it pretty low.

Over the longer term (before using BOSVX, a new fund) we used DFSVX and it's 15 year ranking is 21, and that includes survivorship bias--without which it would be considerably higher.

Best wishes
Tony Pow profile picture
Yes, Larry. Another ETF based on value is beating the market by a good margin for the last several years. Forgot the name of the ETF. It does not buy the entire market but selectively.

In my book Scoring Stocks, convincingly the highly-scored stocks always the rest of the stocks as a group by a good margin over time. Besides fundamental metrics, it includes company's sector prospect and its sector's prospect.

The book used Apple (I first used IBM which scored too low for the book) as an example. It scored very high and its stock price was $390.05 at the time. The book was published in early May.
Tony Pow profile picture
Great article.

The following concept is from my book Myths.

When we buy value stocks, we're swimming against the tide, so it will take at least 6 months for the market to realize the potential values.

Besides the basic fundamental metrics, we need to do a qualitative analyze (Seeking Alpha is a good source) to check the company's prospect and the sector prospect.
Equanimity Investing profile picture
Not necessarily. You can buy an undervalued stock with a favorable trend/technical chart and start making returns directly after your purchase.
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