The value premium, which was first identified by Eugene Fama and K.G. French in 1992, refers to the greater risk adjusted return achieved by value stocks over glamour stocks. Value stocks are defined as stocks that trade at low prices relative to its dividends or earnings. Glamour stocks on the other hand are stocks which attract a large number of investors and therefore trade at high prices relative to its fundamental values e.g. dividends and earnings. Fama and French indentified this premium using a value strategy called HML, which quantifies the difference between returns on a portfolio containing stocks of high book-to-market firms (value stocks) and returns on a portfolio containing stocks of low book-to-market firms (growth stocks).
Over the years, financial analysts have argued why value stocks yields a higher return as opposed to growth stocks when it's supposed to be the other way round i.e. the latter is riskier than the former as it is affected by the uncertainty of external factors. These growth opportunities on these stocks allow it to fair in good times and are responsible for high systematic risk on the stock (Hiller, 2001). Ramey and Shapiro (2001) explain that in bad times, value firms tend to have a negative downturn in trying to reduce capital stocks compared to growth firms as they possess real assets. Theorists such as Vassalou (2003) proposed that this premium is as a result of systematic risks not captured by the Capital Asset Pricing Model.
The value premium appears to be contrary to the Efficient Market Hypothesis (EMH) due to numerous reasons. To begin with, the EMH refers to the notion that market prices fully reflect all available information. An efficient capital market refers to a market where stock prices reflect all accessible information fully, quickly and accurately.
Value strategies produce higher returns because it employs a strategy of doing the opposite of what most investors will do, otherwise known as the contrarian strategy, i.e. buying stocks that have been out of favour for long periods of time and are therefore mispriced. This is contrary to the EMH as it postulates that prices are reflective of all available information, and that any mispricing that exists would be temporary and rapidly corrected. The EMH also states that no investor should be able 'beat the market'. However contrarian strategies, which buy past losers and sell past winners produce large long-horizon excess returns consistent with overreactions thus arbitrage is achieved, effectively beating the market.
The EMH also states that stocks trade at fair value, and no arbitrage opportunities should exist with either under or over priced stocks, however with this value premium that is obtained from implementing the contrarian strategy, investors look for small windows by noting when the consensus seems to be clustered.(Fama and French). In addition, contrarian investors look at stocks that are mispriced due to overreactions from investors by overpricing stocks that have performed well in the recent past and simultaneously under pricing stocks that have performed badly recently.
Furthermore, the EMH states that forecasts errors should be more or less zero, however in the case of the 'value premium' investors make methodical errors in projecting future growth in earnings of out-of-favour stocks. This is due to the fact that analysts extrapolate past performance too far into the future; this therefore causes a subsequent overpricing of firms with good recent performance and under pricing firms with recent poor performance.
Part B
There are controversial views about the causes of value premium. This paper analyses three main current explanations for the value premium, these being; rationalists, behavioralists and the random occurrence views. However, there is a debate as to which view is more acceptable.
Rationalists
The first alternative explanation of the value premium is that of the Rationalist. They are of the opinion that value strategies produce superior returns as they are fundamentally riskier than glamour stocks especially in bad times when the price of risk is high. The Rationalists argue that because of the high risk in holding value stock, the value premium provides them a compensation for this risk. Fama and French (1996, 1998) further emphasized this notion by saying there exist a variation in returns between distressed stocks thereby making investors require a higher return for the systematic risk they bear.
Dana (2006) noted that since value firms are more exposed to long-run consumption shocks, they show higher elasticity of their price/dividend ratios to long run consumption news, hence they have to provide investors with high compensation for risk. Fama & French (1993, 1995, 1996) argue that the value premium serves as compensation for risk not captured by CAPM. This follows from the fact that there is a difference in earnings of distressed stocks not captured by the market returns.
Zhang (2005) argues that the value anomaly arises naturally in a neoclassical scenario where rational expectations hold. Furthermore, it has been argued that such premiums are only evident depending on the current state of the economy. For example, as growth firms are typically more productive relative to value firms and they tend to invest more and grow faster than value firms, which is especially the case during "good times". Moreover, value is usually riskier than growth in "bad times" as firms are more likely to disinvest. This is because value stocks are typically in distress and if a large-scale recession was to occur these stocks would perform badly.
Another school of thought which is in contrast to the Rationalist, the Behavioralist or irrational view, which explains the value premium as an "extrapolation" or "errors-in-expectations" that seeks to link future returns to psychological biases of investors rather than the economic issues of the economy leading to mispricing of value stocks (Zhang, 2005). They believe that investors overreact to good or bad news which are being exploited to yield higher returns. This means that poorly performed value stocks are oversold, become underpriced and later adjusted when investor sentiment raises its prices.
LSV (1994) argue that cognitive biased investors extrapolate past growth records of "glamour stocks" and purchase them at a price, not minding whether they are overpriced or underpriced thereby gaining value premium on the long run. Investors are seen to act naively estimate the recent earning trends and adjust their earning expectations as shocks occur. In the Fuller et al (1992) study, they found that glamour stocks are initially highly mispriced with anticipated growth rates than low priced value stocks. But over time as the market adjusts, value stocks become highly priced earning higher returns than growth stocks. Investors often relate the brand equity of a company to higher expected returns and research has shown that these stocks most times underperform (REFERENCE NEEDED).
The Behavioralists also argue that value stocks produce higher returns mainly as a result of investors' consistently overestimating the future earnings of growth stock relative to value stocks. This argument is premised on the fact that investors are pessimistic about the value stocks because their future earnings expectation is tied to past earnings. Value Strategies are also seen to produce higher returns because they are contrarian to "Naive Strategies", which have to do with extrapolating past earnings growth too far into the future. Due to this, an assumption is made for trends in stock prices to overreacting to good or bad news or simply assuming investment in a well run company is a good investment irrespective of price. Doukas et al (2002) observed that the essence of extrapolation is that investors are excessively optimistic about glamour stocks and excessively pessimistic about value stocks because they relate their expectations of future growth to past growth. It is believed that value strategies have produced better results because they take advantage of the mistakes of naive investors. Daniel et al. (2002), Barberis et al. (1998) and Hong and Stein (1999) observed that "mistaken beliefs cause stock price momentum and reversals".
Evidence has been provided against the error-in-expectations view of future earnings. It was observed that the abnormal returns of value stock on earnings announcement day was not caused by surprise in level of earnings but by the mechanism of disagreement about future returns of company stock amongst investors. This disagreement arose because imperfect capital market equilibrium requires determining the prices of assets and also the identity of investors trading in each asset at the same time.(reference needed)
During a study carried out between 1976-97, Doukas et al (2002) found that investors made systematic errors in predicting future growth in earnings for value stocks i.e. there is asymmetric information within the market thus resulting in an inefficient outcome.
The final explanation of the value premium is attributed to random occurrence which is unlikely to occur again in the future. (Lo and MacKinlay 1988, Breen and Korajczyk 1995 and Kothari, Shanken and Sloan 1995). In this situation, the value premium is seen as a game of chance, not as a reward for risk or a basis for a profitable trading strategy. Although, arguments have been put forward to question the validity of this explanation as Seymour Smid (2009) argued that stock prices cannot fluctuate in a random manner especially these days when stock market prices are influenced by economic, political and other factors which do not follow a random occurrence.
Conrad et al (2003) argue that the firm characteristics that exhibited the highest degree of predicative ability were the ones that have captured the attention of other researchers, such as Fama and French (1992) and Lakonishok et al (1994). Furthermore Conrad et al argues that these authors had, "excessive familiarity with the data". If this is the case then the value premium only exists as a result of data-cropping and creates a bias towards firms with favourable data which is relatively easy to extrapolate.
According to the Evolutionary finance approach of Evstigneev, Hens, and Schenk-Hoppe (2006), it was argued that excess returns from value investment stems from the market's tendency to converge towards fundamental values. It was claimed that value investment works as a result of the temporary displacement of the financial market from the long run equilibrium, which is later restored back to normal.
Conclusion
As stated earlier, there is no widely acceptable explanation of the value premium and its sources. Research shows that the Behaviouralist view is marginally better at explaining the alternative explanations for the value premium (reference needed).
Refrences:
Conrad, J., Cooper, M. & Kaul, G. 2003. Value Versus Glamour. Journal of Finance, 58, pp.1969-1995.
Doukas, J., Kim, C. & Pantzalis, C. 2002. A Test of the Errors-in-Expectations Explanation of the Value/Glamour Stock Returns Performance: Evidence from Analysts' Forecasts. Journal of Finance, 57, pp.2143-2165.
Fama, E. 1998. Market Efficiency, Long-Run Returns, and Behavioural Finance. Journal of Financial Economics, 33, pp.283-306.
Fama, E. & French, K. 1993. Common Risk Factors in the Returns on Stocks and Bonds. Journal of Financial Economics, 33, pp.3-56.
Fama, E. & French, K. Value Versus Growth: the International Evidence. Journal of Finance, 53, pp.1975-1999.
Lakonishok, J., Shleifer, A. & Vishny, R. 1994. Contrarian Investment, Extrapolation and Risk. Journal of Finance, 49, pp.1541-1578.
Liew, J. & Vassalou, M. 2000. Can Book-to-Market, Size and Momentum be Risk Factors that Predict Economic Growth? Journal of Financial Economics, 57, pp.221-245.
Lo, A. & MacKinlay, C. 1990. Data Snooping Biases in Tests of Financial Asset Pricing Models. Review of Financial Studies, 3, pp.431-468.
Vassalou, M. 2003. News Related to Future GDP Growth as a Risk Factor in Equity Returns. Journal of Financial Economics, 68, pp.47-73.
Zhang, L. 2005. The Value Premium. Journal of Finance, 60, pp.67-1
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Dana Kiku (2006) Is the Value Premium a Puzzle? , Finance Seminar
