What is Value Premium?

Is Value Premium a Free Lunch?

Value premium refers to the observation that value stocks tend to return better than growth stocks on a risk-adjusted basis. Fama and French defined the value premium as the difference in returns between high book to market stocks and low book to market stocks, also referred to as HML. Value premium has been shown to persist over all asset classes for long term holding periods.

The reasons for the existence of a value premium are not clear. There are different hypotheses put forward to explain the value premium puzzle.

Value Premium and Default Risk

One hypothesis says that value stocks are typically companies in distress (learn more about distressed debt market), or otherwise with volatile earnings and share prices. This makes value stocks riskier than growth stocks. Since investors are highly averse to perceived risk, the rewards of investing in value stocks are correspondingly high.

Learn more: risk premium

However, this does not explain the value premium. While the argument has some merit, it suffers from the asymmetry in how the risk is viewed. Most value investors would view growth stocks as inherently more risky as the investment success depends on correctly predicting future earnings and cash flows, which are always tricky (and hence it is more likely that you will predict these wrong). Value investing on the other hand depends on the known quantities, such as past earnings, companies returns on various operating metrics, and the value of the assets.

See also: book value of equity formula

Value Premium and Investor Sentiment

Another hypothesis tries to explain value premium as a behavioral phenomena. Studies have noted that the value premium increases during bad economic times and rising interest rates and decreased during an expanding money supply or an economic boom. To me, this again boils down to the perception of risk. Several others have posited that investor biases come into play as investors tend to over estimate their skills in predicting future cash flows for growth companies and tend to de-emphasize  the things that have already happened (assets in the ground, so to speak).

Regardless of what drives the value premium, risk or mispricing due to investor biases, it remains a fact of the investment landscape. it is very likely a core feature of the investor behavioral psychology as it has been observed to exist across countries and persist over time.