A Study of the Causes of the Value Premium Observed in Academic Literature

The international financial market community has seen the appearance of the discussion of a value premium of value stocks (low P/E ratio) compared to growth stocks (high P/E ratio). Existing literature has tried to explain this value premium, earned by value stocks rather than growth stocks. One side of the argument is it is caused by the higher risk associated with value stocks as well as the cognitive biases that are inherent to investors’ behaviour. The other side is that it is purely caused by a data-selection bias. Other theories relating to the cause of the value premium will also be discussed.

First we need to establish the existence of a value premium. In Basu (1977), the efficient market hypothesis is put to a test. It states that security prices fully reflect available information free from bias and thus provide unbiased estimates of the underlying values. This would mean that investors are not able to earn excess returns. As discovered, the P/E ratio hypothesis seems to be more relevant as excess earnings have indeed been incurred. Basu (1977) states that P/E portfolios seem to have, on average, earned higher absolute and risk-adjusted rates of return than the high P/E securities, being generally true when bias in the performance measures resulting from risk is taken into account.

Capaul et al. (1993) suggest that if we employ the capital asset pricing model (CAPM), which evaluates an asset’s rate of return considering its systematic risk. In this case, a strategy which solely included value stocks, could have added to the overall performance of the portfolio. It was also noted that investing 100% of one’s funds in the value index dominated any combination of both indexes combined, except those with short positions in the growth index. However, it needs to be mentioned that this only applies to before tax returns.

Moving on we criticise the capital asset pricing model. Fama and French (1998) discover that an international CAPM cannot explain the value premium in international returns unlike a one-state-variable international ICAPM that explains returns with the global market return. It also includes a risk factor for relative distress that captures the value premium in country and global returns. They do not, however, wish to push a strong asset-pricing story. The ICAPM rather provides a parsimonious way to summarize the general patterns in international return.

A criticism by Lakonishok et al. (1994) to this finding is that value stocks yield higher returns because they exploit the cognitive bias of the typical investor rather than being fundamentally riskier. If we assume value stocks and growth stocks to be equally risky, then value stocks have always been undervalued and thus gaining excess returns was possible. Lakonishok et al. (1994) suggests that the reasons behind the value premium is that the actual future growth rates of earnings, cash flow, etc. of growth stocks