|
Blog > Posts > Value Premium 101
|
Back to Home
2/14/2012
Value Premium: Returns
Historically, stocks with low prices relative to earnings, accounting book value or cash flow (among other metrics) have outperformed stocks with high prices relative to these same metrics. The “low price” stocks are called value stocks, and the “high price” stocks are referred to as growth stocks. The overall phenomenon is called the value premium. In the U.S., the value premium — when measured using accounting book value — has averaged 4.9 percent per year from 1927–2010.
In one form or another, the value premium has been discussed going back (at least) to Benjamin Graham and David Dodd’s Security Analysis, which was originally published in 1934. The formal documentation of what academics and practitioners now refer to as the value premium is attributed to Eugene Fama and Ken French’s 1993 paper “Common Risk Factors in the Returns on Stocks and Bonds,” in which they found a value premium in the U.S. of 0.40 percent per month for the period July 1963–December 1991. To put the size of this return premium in perspective, this was only 0.03 percent less than the equity premium over that same period of time. Fama and French followed up with other papers documenting similar results in international stock markets and during earlier periods in the U.S. Like the momentum premium, the value premium has been stronger in small-cap stocks compared to large-cap stocks.
Value Premium: Risk
Annual volatility of the value premium has been about 14 percent per year, and it has been positive in the U.S. in 63 percent of years from 1927–2010. One interesting aspect of the value premium is how it tends to do during periods of poor stock market performance. In years when the equity premium was negative (meaning years where the overall equity market underperformed one-month Treasury bills), the value premium has averaged 5.0 percent, even higher than its overall average of 4.9 percent. This indicates that the value premium may be volatile, but it still has strong potential diversification benefits. Yet the value premium isn’t always positive in negative market years. The Great Depression era had a couple of years of negative equity and value premiums. (For example, in 1931 the equity premium was –45.4 percent and the value premium was –15.9 percent. OUCH!)
Value Premium: Why Does it Exist?
The cause of the value premium invokes an argument I’m beginning to believe will never be settled. Proponents of a risk-based explanation point to the performance of the value premium during the Great Depression and the general characteristics of value stocks (low profitability, low earnings growth and high leverage in some cases) relative to growth stocks to argue that it must be a risk story.
Others point to the dot-com bubble — when many growth stocks traded at astronomical valuations — and the subsequent phenomenal performance of value relative to growth in 2000–2002 when the equity premium was negative as evidence that the value premium can’t be compensation for risk. In reality it’s likely partly compensation for risk and partly not, and I think that’s about all anyone can conclude from looking at the data.
Random Links of the Week
Copyright © 2012, Buckingham Family of Financial Services. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site. |
|
|
|
|
|
|
|
 |
 | Jared Kizer
Director of
Investment Strategy
BAM Advisor Services
(see bio)
|
|
|
|
|
|