The Value Premium Puzzle: A Review of Empirical Evidence and Solutions

The value premium puzzle

Alexis Eisenhofer

ATACAMA Capital

4th Value Investor Conference
Los Angeles, 8th of May 2007

Alexis Eisenhofer The value premium puzzle 1/29

Empirical evidence: The value premium
The puzzle: The contradiction to the CAPM
Solutions: A review of the literature
Conclusion

Table of contents




Conclusion


Conclusion

Table of contents




Conclusion


Conclusion

Investment professionals often classify stocks to a few
number of investment styles1

Small Caps Mid Caps Large Caps
MCAP < 1 bln. USD 10 bln. USD ≥ MCAP ≥ 1 bln. USD MCAP > 10 bln. USD

Value Low PE; high BtM Low PE; high BtM Low PE; high BtM
High DivYld High DivYld High DivYld

MCAP < 1 bln. USD 10 bln. USD ≥ MCAP ≥ 1 bln. USD MCAP > 10 bln. USD

Growth High PE; low BtM High PE; low BtM High PE; low BtM
Low or no DivYld Low or no DivYld Low or no DivYld

MCAP := Market capitalization; PE := Price/earnings ratio; BtM := Book-to-market ratio;
DivYld := Dividend yield

1
Basu (1977), Banz (1981), Fama/French (1992)

Conclusion

The value premium: In the long run value outperforms
growth (and small stocks outperform large stocks)


Conclusion

Growth stocks only outperformed value stocks in times of
stock market bubbles


Conclusion

The one-year growth and value trend is quite volatile...


Conclusion

...but becomes more apparent with a longer (e.g.
three-year) time horizon


Conclusion

The value premium has been seen in many countries but...


Conclusion

...the magnitude of the value premium diﬀers very much
across countries


Conclusion

Low correlations indicate that there are no simultaneous
”value phases” across all countries


Conclusion

Table of contents




Conclusion


Conclusion

The capital asset pricing model postulates a direct relation
between expected return and systematic risk2

Capital asset pricing model Reward-to-risk ratio
µi
6 µi = rf + (µm − rf ) · βi (1)
Security market line
Cov (ri ; rm )
q

µm m βi = 2
(2)
σm

rf
rf := Risk-free rate;
µm := Expected return of the market;
βi := Systematic risk of asset i;
- βi
βm = 1

2
Sharpe (1964)

Conclusion

Even though value stocks oﬀered higher returns to the
investor their risk was lower


Conclusion

The drawdown of value stocks was lower while their upside
potential was almost equal to growth stocks


Conclusion

The assumptions of the CAPM are very simple and hardly
reflect real investor behavior

Major CAPM assumptions... ...conflict with reality
1 All investors share the same ⇔ 1 Investors are not perfectly
information and act rationally informed and are irrational
2 Returns are distributed ⇔ 2 Time varying nonsymmetric
normally distributions
3 All investors hold the (same) ⇔ 3 Investors hold different
market portfolio portfolios
4 Frictionless and efficient capital ⇔ 4 Transaction costs and
markets inefficiencies


Institutional imperative and overestimation
Empirical evidence: The value premium Investor disagreement
The puzzle: The contradiction to the CAPM A Duration-based explanation
Solutions: A review of the literature Fixed-income hedging
Conclusion Evolutionary ﬁnance
Transaction costs and institutional ownership

Table of contents




Conclusion



The value premium can be explained by emotions and
cognitive errors of investors

The institutional imperative (managers tend to act like their
peers) leads to investments in ”glamor stocks”, even if their
valuation is inferior to ”unknown” stocks3
Investors are too optimistic because they naively
extrapolate earnings trends and stick too long to high
growth rates4
Hope and fear drives overvaluation (undervaluation) of
growth (value)

3
Buﬀett (1989)
4
DeBondt/Thaler (1987)


Value stocks and small-cap stocks earn higher returns
because there is greater disagreement about the stocks
future payoﬀs5

The divergence in analysts earnings forecasts is a proxy for
investor disagreement
Value stocks have a greater divergence of opinion than
growth stocks
Small-capitalization stocks exhibited greater forecast
dispersion than stocks of large companies

5
Daniel/Titman (1997)


Growth companies have higher betas because of their high
duration of cash flows while their low covariance to cash
flow risk accounts for lower returns6
Risk is explained through cash flow risk and discount rate
risk (Duration)
Value stocks, as short-horizon equity, vary more with
fluctuations in cash flows (⇒ lower Duration); Growth
stocks, as long-horizon equity, vary more with fluctuations
in discount rates (⇒ higher Duration)
Investors fear cash flow risk far more than discount rate risk
which is why value investors claim a premium on their
investment
6
Lettau/Wachter (2005)


The value premium can be explained as an insurance for
institutional investors because growth stocks offer a good
hedge against fixed-income risk7

Value stocks with constant dividends are similar to
fixed-income instruments such as bills, bonds and loans
Institutional investors such as life-insurance companies,
banks and pension funds typically invest heavily in
fixed-income instruments
Despite the sizeable premium for value stocks, growth
stocks are attractive to these investors because they offer a
good hedge against fixed-income risk

7
Post/Van Vliet (2006)


The value strategy dominates a growth, momentum or
glamor portfolio in the long run due to the convergence of
markets towards fundamental values8

A Darwinian approach: The market as a heterogeneous
population of portfolio strategies in competition for market
capital
The value strategy wins because markets tend to converge
towards fundamental values
This convergence property gives rise to a predictability of
asset returns based on fundamental criteria

8
Hens/Schenk-Hopp´/Woehrmann (2006)
e


The value premium persists because of market
imperfections and is negatively correlated with the degree
of institutional ownership9

The value premium can persist because transaction costs
and short selling constraints keep away arbitrage trades
Institutional investors are better informed of the value
premium and have a better market access to proﬁt from value
mispricings
Companies with larger institutional ownership (typically
larger companies) carry a smaller value premium

9
Phalippou (2004)

The puzzle: The contradiction to the CAPM Bibliography
Solutions: A review of the literature Contact
Conclusion

Table of contents




Conclusion


Conclusion

Value investing is a superior investment style in the long
run

The value premium has been seen for many years and will
probably persist in the future
Small cap stocks show a higher premium than large caps
The correlation of the value premium in diﬀerent countries
is low
Behavioral rather than rational aspects can ”solve” the
puzzle


Conclusion

References

* Banz, Rolf W. (1981): The relationship between return and market
value of common stocks, Journal of Financial Economics 9, 3-18.
* Basu, Sanjoy (1977): Investment performance of common stocks
in relationship to their price-earnings ratios: A test of the eﬃcient
market hypthesis, Journal of Finance 32, 663-682.
* Buﬀett, Warren (1989): Chairmans letter,
http://berkshirehathaway.com/letters/1989.html.
* Daniel, Kent, and Sheridan Titman (1997): Evidence on the
characteristics of cross sectional variation in stock returns, Journal
of Finance 52, 1-33.


Conclusion

References

* DeBondt, Werner, and Richard Thaler (1985): Does the stock
market overreact?, Journal of Finance 40, 793-805.
* Fama, Eugene F., and Kenneth R. French (1992): The
cross-section of expected stock returns, Journal of Finance 47,
427-465.
* Hens, Thorsten, and Klaus Reiner Schenk-Hopp´, and Peter
e
Woehrmann (2006): An evolutionary explanation of the value
premium puzzle, NCCR FINRISK Working Paper No. 280.
* Lettau, Martin, and Jessica A. Wachter (2007): Why is
long-horizon equity less risky? A Duration-based explanation of the
value premium, Journal of Finance 62, 55-92.


Conclusion

References

* Phalippou, Ludovic (2004): What drives the value premium,
INSEAD Working Paper May 2004.
* Post, Thierry, and Pim van Vliet (2006): Loss aversion and the
value premium puzzle, SSRN Working Paper No. 764164.
* Sharpe, William F. (1964): Capital asset prices: A theory of market
equilibrium under conditions of risk, Journal of Finance 19, 425-442.


Conclusion

Thank you for your attention!

Dr. Alexis Eisenhofer Phone: +49-(0)89-2000320
ATACAMA Capital GmbH Fax: +49-(0)89-20003232
Maria-Probst-Str. 19 eMail: eisenhofer@atacap.com
D-80939 Munich Web: http://www.atacap.com
Germany

This presentation will be available on the web site
http://www.atacap.com/


The Value Premium Puzzle: A Review of Empirical Evidence and Solutions

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The Value Premium Puzzle: A Review of Empirical Evidence and Solutions