The value premium - NAIT

lizardgossypibomaManagement

Oct 28, 2013 (3 years and 7 months ago)

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Anna
Beukes

February 2011


Northern Alberta Institute of
Technology



Value stocks refer to those trading at low
prices relative to fundamental values such as
earnings, book value of assets, and cash flow



Fama

& French (1992) showed that stocks of
value companies outperformed that of growth
companies



Value premium
tested extensively

and widely
in various ways, in
Japan (Chan,
Hamao

and
Lakonishok
, 1991); France, Germany,
Switzerland and the UK (
Capaul
, Rowley and
Sharpe, 1993).



Findings of the value premium
existence very
consistent,

irrespective of method or country



Investigated by various researchers



Most extensive recent test done by Beukes
(2010): using 30 years worth of data and
more than one method of portfolio formation.



The results are very convincing:


Value portfolios consistently outperformed
growth portfolios, regardless of


the length of time the portfolios were carried (one
to five years), or


whether returns were recorded annually (year
-
on
-
year) or for holding purposes (on a buy
-
and
-
hold
basis).


Even after size
-
adjustment, value portfolios still
outperformed growth portfolios by an impressive
margin.


1




2



Academic community has generally come to
agree that value investment strategies, on
average, outperform growth investment
strategies (Chan and
Lakonishok
, 2004:71)



But, still no agreement on how to
explain

the
value premium.



Risk as (default) explanation



Assuming market efficiency, value premium is
a measure of risk


indicating a higher
discount rate that compensates investors for
carrying higher risk.



What risk?
Beta


After “uncovering” the value premium,
Fama

and French (1992) immediately tested beta as
explanation and found no evidence that value
companies are inherently more risky


Had to admit that: …“our bottom
-
line results
are [that]
beta does not seem to help explain
the cross
-
section of average stock returns…”
(1992:428).



Van
Rensburg

(2003) found beta does
not

explain the cross
-
section of average returns
in SA either.


Maybe
beta

“too crude” a risk measure


Heaton and Lucas (1997): value companies
vulnerable

to recessions, business cycle
downturns


Xing and Zhang (2004): fundamentals of
value firms
more adversely affected
by
negative business shocks than that of growth
firms


Liew

and
Vassalou

(1999) tried to link value
firm returns to
macro
-
economic events



Jagannathan

and Wang (1996) and
Reyfman

(1997) used
labor income
as a factor to
explain the value premium


=>
To date no convincing/conclusive evidence
that distress factors provide the explanation


Lakonishok
,
Shleifer

and
Vishny

(henceforth LSV,
1994):
systematic mispricing of value and growth
stocks caused by investors who naively
extrapolate the past growth rates of firms


Value stocks
-

a past history of poor
performance (relative to growth stocks) with
respect to growth in earnings, cash flow and
sales


Investors overestimate sustainability of high
returns on growth stocks; project past growth
too far into the future.


LSV summarized it as follows:


“The essence of extrapolation is that investors
are excessively optimistic about glamour
stocks and excessively pessimistic about
value stocks because they tie their
expectations of future growth to past
growth.” (
Lakonishok
,
Shleifer

and
Vishny
,
1994: 1559)


Test

for extrapolation: look at future growth
rates; compare them to past growth rates.


Must be shown that
growth companies
performed well in the past; that investors
expected strong growth to continue in the
future.


Similarly, it must be shown that
value
companies

performed badly in past; are
expected to continue to perform poorly in the
future.



It is possible to test this notion, because past
performance and future expectations are
two
distinct and separate entities

which can be
evidenced.


Past performance
measured by past growth in
sales, earnings and cash flow.



Expectations

about the future reflected by
multiples of stock price to earnings and cash
flow.


Book
-
value
-
to
-
market
-
value (BV/MV) used
for portfolio formation


Five years of pre
-
portfolio formation data
necessary to test for extrapolation
-

portfolio
formation started in 1977


Three portfolios (top 30%, middle 40% and
bottom 30%) formed annually
-

top 30% the
value portfolio, bottom 30% the growth
portfolio

For each of the two extreme portfolios the
following variables were tracked:


Past performance
(i.e. in the five years
before

portfolio formation) of growth in sales,
earnings and cash flow.


Future performance
(i.e. in the five years
after

portfolio formation) of growth in sales,
earnings and cash flow.



Ratios

such as E/P (earnings/market value of
equity) and C/P (cash flow/market value of
equity) at portfolio formation.


These ratios give an indication of investors’
expectations of what will happen in the
future.

Value


Growth

Growth in…

Before portfolio
formation

After

portfolio formation

Before portfolio
formation

After

portfolio formation

Sales

16.46%

17.07%

21.01%

19.73%

Cash flow

21.10%

29.82%

32.07%

28.03%

EPS (excluding
extra
-
ordinary items)


28.04%


31.05%


27.82%


25.00%

Multiples…at
portfolio formation

Value

Growth

Cash flow/Price

0.0063

0.0016

EPS/Price

0.095

-

0.107


Analysis of Johannesburg Stock Exchange
data for the existence of a value premium
unambiguously confirms that the
premium
also occurred in South Africa

between 1972
and 2001



The major remaining questions:


-

what could explain this?


-

what does the value premium suggest


about the tenability of rational finance


theory?




Risk
: Are there “distress factors” not
captured by beta (systematic risk)?



Fama

& French (1993): “Yes”


Lakonishok
,
Shleifer

&
Vishny

(1994): “No”


Despite substantial research and
arguments, debate rages on
inconclusively


Extrapolation
: Incorporate “less than
rational” decision
-
making into financial
markets (
DeBondt

&
Thaler
, 1985)


the more
likely explanation



“Less than rational” investors extrapolate past
results too far into the future
-

for both value
and growth stocks


“Irrational” behaviour will not disappear
-

rather an
enduring characteristic
of behaviour
in financial markets