The Value Premium Puzzle

The value premium puzzle

Alexis Eisenhofer

ATACAMA Capital

4th Value Investor ConferenceLos Angeles, 8th of May 2007

Alexis Eisenhofer The value premium puzzle 1/29

Empirical evidence: The value premiumThe puzzle: The contradiction to the CAPM

Solutions: A review of the literatureConclusion

Table of contents

Empirical evidence: The value premium

The puzzle: The contradiction to the CAPM

Solutions: A review of the literature

Conclusion




Table of contents




Conclusion




Investment professionals often classify stocks to a fewnumber of investment styles1

Small Caps Mid Caps Large Caps

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

Low PE; high BtM Low PE; high BtM Low PE; high BtMValueHigh DivYld High DivYld High DivYld

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

High PE; low BtM High PE; low BtM High PE; low BtMGrowthLow 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

1Basu (1977), Banz (1981), Fama/French (1992)Alexis Eisenhofer The value premium puzzle 4/29



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




Growth stocks only outperformed value stocks in times ofstock market bubbles




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




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




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




...the magnitude of the value premium differs very muchacross countries




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




Table of contents




Conclusion




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

Capital asset pricing model

6

-

��

µi

µm

rf

βi

βm = 1

Security market line

m qReward-to-risk ratio

µi = rf + (µm − rf ) · βi (1)

βi =Cov(ri ; rm)

σ2m

(2)

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

2Sharpe (1964)Alexis Eisenhofer The value premium puzzle 13/29



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




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




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

Major CAPM assumptions...

1 All investors share the sameinformation and act rationally

2 Returns are distributednormally

3 All investors hold the (same)market portfolio

4 Frictionless and efficient capitalmarkets

...conflict with reality

⇔ 1′ Investors are not perfectlyinformed and are irrational

⇔ 2′ Time varying nonsymmetricdistributions

⇔ 3′ Investors hold differentportfolios

⇔ 4′ Transaction costs andinefficiencies




Institutional imperative and overestimationInvestor disagreementA Duration-based explanationFixed-income hedgingEvolutionary financeTransaction costs and institutional ownership

Table of contents




Conclusion





The value premium can be explained by emotions andcognitive errors of investors

I The institutional imperative (managers tend to act like theirpeers) leads to investments in ”glamor stocks”, even if theirvaluation is inferior to ”unknown” stocks3

I Investors are too optimistic because they naivelyextrapolate earnings trends and stick too long to highgrowth rates4

I Hope and fear drives overvaluation (undervaluation) ofgrowth (value)

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





Value stocks and small-cap stocks earn higher returnsbecause there is greater disagreement about the stocksfuture payoffs5

I The divergence in analysts earnings forecasts is a proxy forinvestor disagreement

I Value stocks have a greater divergence of opinion thangrowth stocks

I Small-capitalization stocks exhibited greater forecastdispersion than stocks of large companies

5Daniel/Titman (1997)Alexis Eisenhofer The value premium puzzle 19/29




Growth companies have higher betas because of their highduration of cash flows while their low covariance to cashflow risk accounts for lower returns6

I Risk is explained through cash flow risk and discount raterisk (Duration)

I Value stocks, as short-horizon equity, vary more withfluctuations in cash flows (⇒ lower Duration); Growthstocks, as long-horizon equity, vary more with fluctuationsin discount rates (⇒ higher Duration)

I Investors fear cash flow risk far more than discount rate riskwhich is why value investors claim a premium on theirinvestment

6Lettau/Wachter (2005)Alexis Eisenhofer The value premium puzzle 20/29




The value premium can be explained as an insurance forinstitutional investors because growth stocks offer a goodhedge against fixed-income risk7

I Value stocks with constant dividends are similar tofixed-income instruments such as bills, bonds and loans

I Institutional investors such as life-insurance companies,banks and pension funds typically invest heavily infixed-income instruments

I Despite the sizeable premium for value stocks, growthstocks are attractive to these investors because they offer agood hedge against fixed-income risk

7Post/Van Vliet (2006)Alexis Eisenhofer The value premium puzzle 21/29




The value strategy dominates a growth, momentum orglamor portfolio in the long run due to the convergence ofmarkets towards fundamental values8

I A Darwinian approach: The market as a heterogeneouspopulation of portfolio strategies in competition for marketcapital

I The value strategy wins because markets tend to convergetowards fundamental values

I This convergence property gives rise to a predictability ofasset returns based on fundamental criteria

8Hens/Schenk-Hoppe/Woehrmann (2006)Alexis Eisenhofer The value premium puzzle 22/29




The value premium persists because of marketimperfections and is negatively correlated with the degreeof institutional ownership9

I The value premium can persist because transaction costsand short selling constraints keep away arbitrage trades

I Institutional investors are better informed of the valuepremium and have a better market access to profit from valuemispricings

I Companies with larger institutional ownership (typicallylarger companies) carry a smaller value premium

9Phalippou (2004)Alexis Eisenhofer The value premium puzzle 23/29



BibliographyContact

Table of contents




Conclusion




BibliographyContact

Value investing is a superior investment style in the longrun

I The value premium has been seen for many years and willprobably persist in the future

I Small cap stocks show a higher premium than large caps

I The correlation of the value premium in different countriesis low

I Behavioral rather than rational aspects can ”solve” thepuzzle




BibliographyContact

References

* Banz, Rolf W. (1981): The relationship between return and marketvalue of common stocks, Journal of Financial Economics 9, 3-18.

* Basu, Sanjoy (1977): Investment performance of common stocksin relationship to their price-earnings ratios: A test of the efficientmarket 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 thecharacteristics of cross sectional variation in stock returns, Journalof Finance 52, 1-33.




BibliographyContact

References

* DeBondt, Werner, and Richard Thaler (1985): Does the stockmarket overreact?, Journal of Finance 40, 793-805.

* Fama, Eugene F., and Kenneth R. French (1992): Thecross-section of expected stock returns, Journal of Finance 47,427-465.

* Hens, Thorsten, and Klaus Reiner Schenk-Hoppe, and PeterWoehrmann (2006): An evolutionary explanation of the valuepremium puzzle, NCCR FINRISK Working Paper No. 280.

* Lettau, Martin, and Jessica A. Wachter (2007): Why islong-horizon equity less risky? A Duration-based explanation of thevalue premium, Journal of Finance 62, 55-92.




BibliographyContact

References

* Phalippou, Ludovic (2004): What drives the value premium,INSEAD Working Paper May 2004.

* Post, Thierry, and Pim van Vliet (2006): Loss aversion and thevalue 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.




BibliographyContact

Thank you for your attention!

Dr. Alexis EisenhoferATACAMA Capital GmbHMaria-Probst-Str. 19D-80939 MunichGermany

Phone: +49-(0)89-2000320Fax: +49-(0)89-20003232eMail: [email protected]: http://www.atacap.com

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


The Value Premium Puzzle

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