Larry Swedroe is a first-rate analyst. He is the director of research and a principal of both Buckingham Asset Management and BAM Advisor Services in St. Louis. He is also a prolific writer of many, many books and articles on investment strategies and although he adds a disclaimer to everything he writes that his opinions and comments are his own and not of his two companies, his work is so well received that hardly anybody can find fault with it.
Larry sent me some thoughts recently on the source of the value premium. You don't hear too much about this but it does bear some watching.
As a preamble, he believes that no objective has stirred explorers more than the search for the source of the Nile. "There is a financial equivalent of that hunt," he says. "Since the publication of the study by Eugene F. Fama and Kenneth R. French, "The Cross-section of Expected Stock Returns" in the Journal of Finance in June 1992, financial economists have been trying to discover the source of the value premium."
According to Swedroe, in recent years there have been numerous papers published concluding that the source of the value premium was really risk. "In that regard, economists have found that value stocks have characteristics that are intuitively risky. These are high volatility of both earnings and dividends, high leverage, and high standard deviation."
In fact, he points our that studies have also found that the risk premium results from value stocks being risker than growth stocks in bad times (and less risky in good times, though to a lesser extent). "Because investors are risk averse, they require a large premium to accept that risk."
To be fair and balanced about this, Swedroe notes that on the other hand there are also many studies finding that the source of the value premium is at least to some degree a behavioral error--what he terms, an anomaly. "These studies find that investors persistently overprice growth stocks and underprice value stocks. The source of the mispricing is that investors persistently underestimate the power of the reversion to the mean of abnormal earnings growth, be it abnormally high or abnormally low. They may also confuse the familiar, or growth stocks, with the safe ones, and thus overpay for growth stocks."
He calls particular attention to the June 2005 edition of the Journal of Finance which contains two articles that says the source of the value premium is risk. "Motohiro Yogo's 'A Consumption-Based Explanation of Expected Returns' found that value (and small) stocks deliver low returns during recessions, when the marginal utility of consumption is highest. In other words, the returns of value (and small) stocks are more procyclical than growth (and large). Thus investors, he notes, must be rewarded with high-expected returns to hold these risky stocks."
In addition, he says that Ralitsa Petkova's "Do the Fama-French Factors Proxy for Innovations in Predictive Variables?" found that value (and small) tend to be firms under distress, with high leverage and high uncertainty of cash flow. "Therefore, shocks to the default spread (the spread between bonds of highly rated bonds and lower-rated credits) explain the cross-section of returns and is consistent with value being a measure of distress risk."
Moreover, Swedroe emphasizes that growth stocks are high-duration assets (much of their value comeing from expected future growth), making them similar to long bonds. "Value stocks are low-duration assets, making them more similar to short-term bonds. Thus, shocks to the term spread (the difference between short-term bonds and long-term bonds) also explain the cross-section of returns and is also consistent with value being a measure of distress risk."
According to Swedroe, when Fama and French first published their famous paper, they hypothesized that the value premium was a risk premium. He notes that while there is certainly evidence that at least part of the value premium is a behavioral story (an anomaly unrelated to risk), he does believe there is a large and growing body of evidence that has found consistent risk-based explanations for the value premium.
He concludes by noting that if value stocks are riskier, as the evidence suggests, they should offer higher returns as compensation. In addition, If value stocks have higher returns because investors make pricing mistakes and refuse to learn from their behavioral errors, then value stocks will still have higher returns. "Either way (or in some combination), investors willing to look different from a market portfolio should consider tilting toward value stocks."
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