Swedroe: Finding The Source Of Value

November 29, 2017

There has been long and great debate as to the source of the value premium. There is a belief among many academics that the value premium is actually an anomaly (in contradiction to the efficient markets hypothesis) and the result of persistent pricing errors made by investors.

For example, those from the “behavioral school” of finance believe investors naively extrapolate past growth when evaluating a company. Thus, they overreact to that information, resulting in a situation where growth companies are persistently overpriced and value companies are persistently underpriced.

Behavioralists also find that investors often conflate familiarity with safety. Because they tend to be more familiar with popular growth stocks, those stocks tend to be overvalued.

In any case, the argument rages on among financial economists over whether the value premium is risk-based or behavioral-based, with supporting evidence on both sides. And it is certainly possible the issue isn’t either black or white, with both the mispricing and risk explanations playing a role in the premium.

Recent Supporting Research

Hui Guo, Chaojiang Wu and Yan Yu contribute to the literature on the source of the value premium with their study “Time-Varying Beta and the Value Premium,” which appears in the August 2017 issue of the Journal of Financial and Quantitative Analysis. Their study covers the period July 1963 through December 2012. Following is a summary of their findings:

  • There’s a strong countercyclical variation in the value premium’s market beta. Macroeconomic variables are informative in estimating the conditional (that is, conditioned upon the state of the economy) capital asset pricing model.
  • Consistent with risk-based explanations for the value premium, its market beta increases sharply during business recessions and decreases during business expansions—value stocks become riskier (safer) in bad (good) times, helping explain the value premium. Specifically, there was a sharp spike in the value premium’s conditional beta in each of seven business recessions over the period July 1963 to December 2012. In addition, the conditional beta tends to decrease during business expansions.
  • Value’s conditional market beta correlates positively with unemployment. As unemployment rises (falls), the beta of value stocks increases (decreases), increasing (decreasing) their risk.
  • Value’s conditional market beta correlates negatively with industrial production. As industrial production falls (rises), the beta of value stocks rises (falls), increasing (decreasing) their risk.
  • Disaster risk accounts for a substantial portion of the value premium due to higher investment adjustment costs (value companies tend to have more irreversible capital).
  • The conditional beta correlates negatively with the procyclical inflation rate and price-to-earnings ratio—value stocks become more (less) risky in bad (good) times.
  • The results were robust to various periods, including from 1949 through 2012 (the longest period for which unemployment data was available) and also from 1927 through 2012.

Guo, Wu and Yu concluded: “Our novel evidence of a strong correlation of the conditional beta with key aggregate economic activity gauges suggests that investment-based models remain a viable explanation of the value premium.”

Their findings are consistent with other research that has found a risk-based explanation for the value premium. I’ll review some of that literature, beginning with the 1998 paper “Risk and Return of Value Stocks.”


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