Swedroe: Explaining The Value Premium

December 15, 2014

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).

Attend Inside ETFs, the World's Largest ETF Conference!



Find your next ETF

Reset All