The value factor clearly works, but the explanations for why vary.
Historically, 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 to explain its existence.
The Classic Theory
The theory from classical financial economics is that value stocks are the equities of riskier companies. Their prices co-move with some risk factor, be it distress, liquidity or the “black swan” risk of an extremely negative economic event.
Finance professors Eugene Fama and Kenneth French constructed a proxy for this risk factor. Their HmL (high minus low) factor (the return of stocks with high book-to-market values minus the return of stocks with low book-to-market values) 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, behavioralists believe the premium results from pricing mistakes in the market. They argue that investors persistently overprice growth stocks and underprice value stocks. Behavioralists point out that while it may be true some risk factors are priced, the return premiums associated with these factor portfolios are simply too large, and their covariance with macroeconomic factors too low, to be considered compensation for systematic risk.
The debate between these competing explanations is important in determining whether the value premium is indeed compensation for risk, in which case, a risk-averse investor might then wish to avoid incremental risks, or a “free lunch,” in which case, all investors would benefit from exposure to it.
A recently published paper provides support for the risk-based explanation. But before we review its findings, we’ll take a look at the findings of a related study.
Lu Zhang—author of the study “The Value Premium,” which was published in the February 2005 issue of The Journal of Finance—concluded that the value premium could be explained by the asymmetric risk of value stocks.
Value stocks are much riskier in bad economic times and only moderately less risky in good times. Zhang explains that the asymmetric risk of value companies exists because value stocks are typically firms with unproductive capital. Asymmetric risk is important because:
- Investment is irreversible—once production capacity is put in place, it is hard to reduce—and value companies carry more nonproductive capacity than growth companies.
- In periods of low economic activity, companies with nonproductive capacity (value companies) suffer greater negative volatility in earnings because the burden of that nonproductive capacity increases and they find it more difficult to adjust capacity than 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. In bad times, adjusting the level of capital is a difficult task, and is especially so for value companies.
When these facts are combined with a high aversion to risk on the part of investors (especially when that risk can be expected to show up when the employment prospects of such investors are more likely to be in jeopardy), the result is a large and persistent value premium.