Swedroe: 2 Views On Value Converge

One of the great debates in finance is whether the source of the value premium is risk-based or behavioral-based. Many academics believe the value premium is actually an anomaly (in contradiction to the efficient markets hypothesis) and the result of persistent pricing errors made by investors.

Adherents to the “behavioral school” of finance, for instance, argue that investors naively extrapolate past growth when evaluating a company and therefore overreact to that information, resulting in an environment where growth firms are persistently overpriced and value firms are persistently underpriced.

Behavioralists also find that investors confuse the familiar with the safe. Because they tend to be more familiar with popular growth stocks, those stocks tend to be overvalued.

Many academic papers provide support for a risk-based explanation for the value premium. For example, research has found that value stocks are typically characterized by high volatility of earnings and dividends, high leverage, significant irreversible capital, and have returns more procyclical than the returns to growth stocks—they are more susceptible to distress risk in bad economic times. And assets that tend to do poorly in bad times should command a risk premium.

While the debate between the behavioral-based and risk-based schools persists, given the weight of the evidence on both sides, it’s almost certainly true that both the mispricing and risk explanations play a role in the premium.

Equity Value As Call Option

John Birge of the University of Chicago’s Booth School of Business and Yi Zhang of the Illinois Institute of Technology contribute to the literature regarding the value premium with their October 2017 study, “Default Risk Premia and a Non-Linear Asset Pricing Model.”

They begin by explaining: “The value of an equity investment can be framed as an embedded call option on a firm’s assets. The embedded call option creates a non-linear relationship between stock returns and underlying risk factors; however, such option value is often underestimated or overlooked in most assets pricing studies.”

They write that, while defaults are relatively rare—around 2% in any year—they can increase quickly and with little warning. When default does occur, debt holders can take control of the company and equity holders usually lose all their value. Given both the significance and unpredictability of the loss, investors require return premiums on equities with greater default risk as compensation.

Birge and Zhang add another risk to the picture—managerial behavior may change when the company is exposed to high default risk, creating conflicts of interest. This situation develops—from the view of firm shareholders—as essentially having a call option on the value of the firm’s assets, with the strike price equal to the firm’s total obligations.

When the firm is exposed to high default risk, with an asset value close to or even below the firm’s total obligations, equity holders have potential upside benefits but little downside risk because the call option gives them rights, but not obligations, to keep the remaining asset value. In effect, the asset becomes like a lottery ticket, a type of investment preferred by many individuals.

Birge and Zhang also note that another conflict, referred to as debt overhang, arises. When a firm faces high default risk, managers have little incentive for making new investments, even those with potentially high ROE. The reason is that the benefits from new investments may only go to existing debt holders. In fact, research has shown that firms in distress tend to reduce investment significantly, and also reduce investments in longer-term assets.

These conflicts can have negative consequences. And of course, investors in distressed companies confront the risk that the companies’ assets will be transferred to the debt holders, wiping out their investments.

The authors further indicate that prior research has found a direct link between the risk of default and the value premium. Their contribution to the literature was that, instead of focusing on economic variables that attempt to measure the probability of default, they focused directly on the prices of individual credit default swaps (CDSs), using them as a proxy for default risk.

A CDS is a swap agreement that requires the seller of the CDS to compensate the buyer when a credit event is triggered. In return, the buyer provides a predefined frequency of payments (CDS spreads) to the seller.

Results

Birge and Zhang limited their data sample to stocks in the S&P 500 because those stocks are the most likely to have a liquid market for CDSs. And by only selecting S&P 500 firms, they avoid the liquidity premium embedded in some smaller firms’ CDS spreads.

Thus, when they build portfolios by terciles by size, keep in mind that the companies they are referring to are all S&P 500 firms, not really small-cap stocks (though they may have very low book values). The period covered in the study is 2005 through 2014. Following is a summary of the authors’ findings:

• Weak stocks (stocks with high CDS spreads) consistently outperform strong stocks (stocks with low CDS spreads) for both value-weighted and equally weighted portfolios, though the difference is larger when using value-weighted portfolios.
• For value-weighted portfolios, returns increase for higher-CDS-spread terciles across all terciles of size and value portfolios. The effect is most pronounced for smaller and higher-book-to-market (value) firms. For example, weak (high CDS spreads) and small-sized firms have an equally weighted monthly return of 1.55%, far larger than the average monthly return of 0.92% for medium-default-risk and small-sized firms, or the average monthly return of 0.68% for weak and medium-sized firms. Similarly, the weak and high-value portfolio has an equally weighted monthly return of 1.23%, larger than the average monthly return of 0.97% for medium-default-risk and high-value firms, or the average monthly return of 0.95% for weak and medium-value firms.
• Weak firms, on average, are much smaller than strong firms, and book value is lower for weak firms.
• The extreme smallest firms in credit-risk portfolios have quite low returns. In fact, when the extremely weak stocks (the 2.5% of stocks with the highest CDS spreads) are separated out, the size premium disappears.
• The results hold when measured against both the single-factor (market beta) CAPM and the three-factor (market beta, size and value) Fama-French models. This suggests that default risks help explain—yet not fully—the size and value premiums.

Summary

Birge and Zhang’s findings are important because they provide both a risk-based and behavioral-based explanation for the value premium. First, they demonstrated that when a firm is not near financial distress, investors require a return premium for holding extra default risk.

However, their finding that when a firm is close to, or in, financial distress, a negative relationship exists between default risk and return, provides a behavioral explanation—there is a well-documented investor preference, or taste, for lottery tickets (assets with positively skewed distributions and fat tails). Thus, value and size portfolios can be improved by screening out extreme weak (high-CDS-spread) smaller stocks.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.