The historical evidence is that there is a very strong and persistent value premium. From 1964 to 2000 large value stocks outperformed large growth stocks 14.5 percent to 11.1 percent, and small value stocks outperformed small growth stocks 16.6 percent to 12 percent. Not only has the value premium been very large, but it has also been very persistent - about equally or more persistent than even the equity premium. In addition to providing greater returns, the standard deviation of value stocks has been lower than the standard deviation of growth stocks. From 1964 to 2000, the standard deviation of large value and large growth was 16.7 and 17.5, respectively. The standard deviation for small value and small growth was 23.8 and 27.2, respectively. (1)

Unfortunately, many investors who examine the data come to the conclusion that the value premium is a free lunch - greater returns with less risk (lower volatility). The problem with this conclusion is very simple: The risk of value stocks just didn't show up in that period.

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. The October 1998 edition of The Journal of Business contains a study, Risk and Return of Value Stocks, by Naifu Cheng and Feng Zhang, which argues that value stocks contain a distress (risk) factor. The authors make their case by examining three factors of distress present in value companies:

1. DIV - Firms cutting dividends by at least twenty-five percent.
2. LEV - A high ratio of debt to equity.
3. SEP - A high standard deviation of earnings.

The authors found that the three factors all captured the returns information (produced high correlation) contained in portfolios as ranked by book-to-market value. When these three factors were present, returns were greater. Since all three factors have simple intuitive risk interpretations (are associated with firms in distress), they state that it isn't surprising that the risk factors they studied were highly correlated and were also highly correlated with book-to-market rankings. Their conclusion was that value stocks are cheap because they tend to be highly-leveraged firms in distress facing substantial earnings risk, and thus provide higher returns due to the greater risks facing value investors.

Another conclusion is that the risks of value stocks are most likely to show up at the worst of times for investors - in times of economic distress. A perfect example of this is the period from 1929 through 1932. During this period the S&P 500 index fell 22.7 percent per annum while risky large value stocks fell 31.8 percent per annum. The even riskier small value stocks fell 36.5 percent, underperforming the S&P 500 index by almost 14 percent per annum for four years. Since investors are on average highly risk averse the value premium has been quite large.

A study, "The Value Premium," by Lu Zhang provides further support to this risk story. His study concluded that that the value premium can be explained by the asymmetric risk of value stocks -"they are more risky than growth stocks in bad times and less risky in good times, but to a much lesser extent." (2)

Zhang explains that asymmetric risk of value companies exists because value stocks are typically companies with unproductive capital. Asymmetric risk is important because:

• Investment is irreversible - once production capacity is put in place it is very hard to reduce. Value companies carry more nonproductive capacity than do growth companies.
• In periods of low economic activity companies with nonproductive capacity (value companies) suffer greater negative volatility in earnings because the burden of nonproductive capacity increases and they find it more difficult to adjust capacity than do growth companies.
• In periods of high economic activity the previously nonproductive assets of value companies become productive while growth companies find it harder to increase capacity.
• In good times capital stock is easily expanded, while in bad times adjusting the level of capital is an extremely difficult task, and is especially so for value companies.
  
  Zhang also observes that:
  
  
• Recessions happen with far less frequency than good economic times.
• The longevity of recessions is far shorter than good times.

When these facts are combined with a high aversion to risk by investors (especially when that risk can be expected to show up when their employment prospects are more likely to be in jeopardy) the result is a large and persistent value premium. The authors of another study, "Equilibrium Cross-Section of Returns," came to the same conclusions as did Zhang. (3)

It is important to point out that the risk of value stocks does not show up in all recessions. While value underperformed in the period 1929-32, the risk of value stocks did not appear in the recession of 1973-74. During this period, while the S&P 500 index fell 20.8 percent per annum and small value stocks fell 22.2 percent per annum, large value stocks fell just 12.3 percent per annum. Why did the risk of large value stocks not show up in this recession? The answer probably lies in the fact that the 1973-74 recession was an unusual one in that inflation actually rose during this period. The CPI rose from 3.4 percent in 1972 to 8.8 percent in 1973. It rose again in 1974 to 12 percent. As noted earlier, the average value stock is highly leveraged. Inflation reduces the real cost of debt, thus reducing the risk of value companies. In fact, the size of the value premium has been highly correlated with inflation.

Before concluding we need to address one more issue that puzzles many investors: How can growth stocks, with their very high prices, be considered safe investments? Investors who wonder how stocks that have such a high valuation can be considered safe are confusing business (operating) risk with price risk. Value companies have more perceived business risk than do growth companies. Therefore, the price of value stocks must be low enough so that investors are compensated for the greater business risk. The distinction is in the risk of the companies, not the risk of their stock prices.

There is another reason why growth stocks might be considered to have more price risk. The less the perceived likelihood of a company failing to reach its projected earnings, the lower will be the risk premium, and the higher the stock price. Taken to an extreme, a stock with very little perceived risk might be said to be "priced for perfection." Simply put, there is little room for any upside surprise. If everything goes as expected, you get low returns (because of the low-risk premium). On the other hand, if almost anything goes wrong, the risk premium might rise sharply, and the stock could fall dramatically. This is the type of price risk that existed in the Nasdaq 100 stocks that were trading at astronomical p/e ratios prior to our entering the new millennium. Conversely, with value stocks being so distressed, there is far less likelihood of disappointment (when the risk premium would rise further) and lots of opportunity for upside surprise (the risk premium would fall and the price would rise dramatically). Some value stocks are so distressed, due to such high perception of risk, that almost nothing else can go wrong that has not been anticipated already. Thus the stock might have a high upside potential should the risk premium fall.

To summarize, it is the perception of a high degree of business risk, and thus a high-risk premium applied to valuations, that causes the price of value companies to be distressed. The same high-risk premium creates high expected future returns. It is the perception of low business risk, and thus a low-risk premium applied to valuations, that causes the price of growth stocks to be elevated. It is high prices that create much higher price risk in the growth stocks than in value stocks.

In conclusion, the value premium has been large and persistent for a very logical reason - value stocks are not only risky, but their risk is highly correlated with economic cycle risk, which tends to manifest itself during recessions that are also deflationary periods. While we do not have a perfect model to explain the risk of value stocks, investors should not make the mistake of believing that just because value stocks have had a lower standard deviation than growth stocks that the value premium is a free lunch.

(1) Dimensional Fund Advisors
(2) Lu Zhang, "The Value Premium." January 2002, http://assets.wharton.upenn.edu/~zhanglu/
(3) Joao Gomes, Leonid Kogan, and Lu Zhang, " Equilibrium Cross-Section of Returns, March 2001. http://assets.wharton.upenn.edu/~zhanglu/

02/11/2002

Larry Swedroe is the author of What Wall Street Doesn't Want You to Know and The Only Guide To A Winning Investment Strategy You'll Ever Need. His third book, Rational Investing In Irrational Times: How to Avoid the Costly Mistakes Even Smart People Make Today, will be published in April 2002 by St. Martins Press. Larry is also the Director of Research for and a Principal of both Buckingham Asset Management, Inc. and BAM Advisor Services in St. Louis, Missouri. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services.

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