Continuing with our series on style premiums, today I will talk about the value premium, or the tendency for value stocks to outperform growth stocks.
What is it?
To define the value premium, we first must define what value means in this context. Like the name implies, a value stock is one where you are paying a lower price for each unit based on a fundamental valuation metric. There are multiple metrics for measuring value in the academic world. The most commonly used is book to market (BtM), or the book value of a company divided by its market value. Others include earnings to price, dividend to price, forecast earnings to price, cash flow to enterprise value and sales to enterprise value.
The fathers of the value premium are Eugene Fama and Ken French. In 1993 they published a paper called “Common Risk Factors in the Returns of Stocks and Bonds” which first discussed the value premium. Since then research has demonstrated the value premium exists in international and emerging markets as well. They discovered the value premium by first ranking all of the stocks in the universe being studied (i.e. US stocks), then ranking them from the highest book to market ratio to the lowest book to market ratio. Next, they took the return of the top 30% of stocks minus the bottom 30% of stocks.
In the US from 1927 to 2012, the value premium was 4.82% per year with a standard deviation (a measure of volatility) of 12.59% per year. The value premium has a correlation to the small [cap] and [market/equity] premiums of 0.01 and 0.22 respectively. The lack of correlation indicates that there is a diversification benefit from gaining exposure to the risk associated with the value premium.
Why It Exists
There are two schools of thought as to why the value premium exists. The risk story is that value stocks generally have low profitability, low earnings growth and high leverage when compared to growth stocks. Because these companies are riskier, there should be a higher expected return for owning them. The behavior story is that investors overpay for the future earnings of growth companies, thereby underpaying for value companies.
How To Capture It
Around the time of the Fama/French paper, DFA released their small cap value fund DFSVX. Since 4/1993 this fund has been able to capture about 82% of the small premium and 65% of the value premium. This is in addition to 100% of the market [equity?] premium. Of course a strategy like this has transactions and other costs that may eat away at potential returns, so how did it do? From 4/1993 until 3/2013 DFSVX has returned 12.25% per year. The S&P 500 over that same time period returned 8.53% per year. This equates to $1 turning into $10.08 for DFSVX versus $5.14 for the S&P 500.
It wasn’t so easy for investors in DFSVX though. For the two year period of 1998-1999 the total return of DFSVX was only 4.79% while the total return of the S&P 500 was 55.63%! Would you have the stomach to watch everyone else around you getting rich while you stayed disciplined?