The existence of a value premium—the difference in returns between high book-to-market stocks and low book-to-market stocks—has been well-documented. However, there’s a major controversy as to its source.
Some believe it can be explained by risk—that value stocks are the stocks of riskier companies. On the other hand, behavioralists believe the premium results from pricing mistakes—that investors tend to persistently overprice growth stocks and underprice value stocks.
Digging Into The Research
Recently, I was discussing this puzzle with a friend, which led me to dig into my files to review the literature. Among the papers I thought were of interest was “The Value Premium and Economic Activity: Long-run Evidence from the United States.”
To test the validity of the risk-based explanation, the authors examined the relationship between the value premium and different macroeconomic variables, such as industrial production, inflation, money supply and interest rates. The study—by Angela Black, Bin Mao and David McMillan—covered the period from 1959 through 2005. Following is a summary of the authors’ findings.
First, in a period of economic expansion when industrial production is rising, value stocks become less risky relative to growth stocks. Thus, the price of value stocks increases 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 bad times, value stocks become more riskier relative to growth stocks. The result is that the price of value stocks decreases faster than growth stocks, and the value premium increases (a sign of increased risk).
Therefore, there is a negative relationship between the value premium and industrial production. This certainly was the case during our most recent recession, which lasted from December 2007 through June 2009, when the value premium was -0.44 percent per month.
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, so the value premium shrinks. When the money supply decreases, stock prices also decrease.
Value stocks decrease more than growth stocks, however, and the value premium increases. The result 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. Stock prices decrease, with the price of value stocks declining faster than the price of growth stocks. That leads to an increasing value premium. Conversely, 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.
Fourth, there isn’t a significant relationship between the value premium and inflation.
Overall, the authors found that value stocks are more sensitive to bad economic news, whereas growth stocks are more sensitive to positive economic conditions.
They concluded that the value premium is largely based on fundamental risk factors within the economy and arises through macroeconomic risk. That’s one vote for the risk story.
Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.