Today concludes our two-part series on the research aimed to provide explanations for risk. We’ll pick up with more research on the topic.
We looked at three different papers in Part I as we sought to assess the value premium through the lens of risk, and today we turn to a fourth paper: The 2005 study “Understanding Size and the Book-to-Market Ratio: An Empirical Exploration of Berk’s Critique.” The authors concluded that there were various rationales simultaneously active in driving the size and book-to-market (BtM) ratio effects. Among the significant drivers are distress risk and less liquidity, which increases trading risks and costs. Both contribute to higher BtM ratios and higher expected returns.
The fifth paper, the 2005 study, “Asset Pricing and the Illiquidity Premium,” asked the question, Does illiquidity attract a premium in equity markets—is it another risk factor in asset pricing? Stocks that are illiquid not only have lower trading volume but are characterized by wider bid/offer spreads.
The authors analyzed Australian data as an out-of-sample test. They noted that various papers on U.S. markets have found turnover and bid/offer spreads do help explain returns. Their conclusion was that 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. This finding is also consistent with a U.S. study that found that low-turnover stocks display many characteristics commonly associated with value stocks. Specifically, lower trading volume is associated with worse operating performance, higher BtM ratios, lower analyst followings, lower long-term growth estimates and lower stock returns over the prior five years.
Our sixth and final paper is the 2014 study, “Value Premium and Default Risk” which covered the period 1927-2011. The authors found that there was a positive relationship between default risk and the value premium for both large and small firms together with a leverage effect.
The researchers concluded: “The results show a positive association between the default premium and the value premium accompanied with evidence for a leverage effect on the value premium. This lends support to the risk-based explanation for the source of value premium. That is, where the default premium captures systematic risk in the macroeconomy and that the value premium is associated with rational decision making on the part of investors. Value stocks characterized by poor performance, earnings and profitability compared with growth stocks are more vulnerable to the risk of default and lead the investors to require a higher return on value stocks as leverage increases.”
Their findings add weight to prior studies that concluded that distressed stocks have higher loadings on value and small-cap risk factors compared to lower-failure probability stocks.
As we have noted, studies have found that value firms have poorer performance, earnings and profitability compared to growth firms. And the greater leverage of value firms increases their risks in times of financial distress. Stocks that do poorly in bad times should command large premiums. Thus, investors demand a higher return on value stocks compared to growth stocks as compensation for higher vulnerability due to financial distress.
While the debate among academics continues, at the very least, the evidence is mounting that Fama and French were at least partly correct—size and the BtM ratio contain important information about risk. They are proxies for the risk of financial distress, default, and trading.
What implication does this have for investors? Those investors seeking higher returns by increasing their exposure to small and value stocks should be careful not to treat the higher expected returns as a free lunch. These stocks have characteristics that not only are intuitive indicators of risk, but the research is piling up in support of the intuition.
While the behavioral explanation—mispricing—might explain part of the value premium, the very best investors might hope for is a free stop at the dessert tray. In other words, value stocks are riskier, and thus there should be a premium, but, historically, the premium has been too large. One of the characteristics of an efficient market is that once an anomaly is discovered, the very act of exploiting it will cause it to rapidly shrink and eventually disappear.
The tremendous outperformance—annual average of 14 percentage points per year of value stocks over the six-year period 2000–2006—is the largest in the post-WWII era and might be partly explained by the publication of papers by the behaviorists, and investors seeking to exploit the anomaly.
If this is true, it may be too late to pick up that free dessert.
Larry Swedroe is director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.
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