What if the Value Premium is Gone?

When I was on CNBC last week, I noted the long underperformance of value stocks. The value guys haven’t led the market in a few years. This is unusual because a large body of academic work has shown that value stocks have historically outperformed the market.

Professor Noah Smith wonders if the value premium no longer exists.

As financial markets improved, we may have seen the entrance of more investors who are willing to do the hard work of digging up obscure and boring companies, and who are willing to go against the herd. If the value premium really was a systematic underpricing rather than a true risk premium, then the gradual development of financial markets would be expected to shrink this premium over time.

There are signs that this is happening. Although value stocks did well in the early 2000s, they have dramatically underperformed since the crisis, even though the market has boomed. Of course, that might simply be a particularly long period of underperformance — we might expect to see value bounce back soon enough. But in fact, the decline has been going on for quite a bit longer than that — the value premium has been falling since the mid-1990s. Coincidentally, that is exactly when the Internet and computerized trading systems made it possible to invest in stocks much more cheaply, and to gather information much more easily.

That would mean that markets are getting more efficient — at least, in this one particular way. But it would also mean that market efficiency takes a very long time to establish itself. If big, systematic mispricings such as the value premium can survive for decades before they are finally traded away, it means that other flaws in the market might be equally long-lived. For example, the momentum factor — another mainstay of standard finance theory — might also be a market flaw that will eventually be shown the exits.

If the market is that inefficient, it also means that stock prices are, in some deep sense, “wrong” — that they are not the best available estimate of a company’s value. That would suggest we should be relying on markets less than we do for things like executive compensation. So watch to see if the value premium comes back. If it doesn’t, it means it might never have been about risk in the first place.

It’s an interesting thought. The only thing I would add is that value investing suggests that the market is both right and wrong. It’s inefficient in that values emerge and efficient in that it recognizes the error.

Make that two things. I’m curious how much financial stocks have weighed down value indexes. The sector hasn’t been too strong since, oh, about 2006.

Here’s a look at financial stocks divided by the S&P 500 (in blue) and value stocks divided by the S&P 500 (in black). (I apologize if it looks confusing.)

The point being that the performance of financials seems to be related to the performance of value. Note that that relationship has parted ways in the last two years. Nevertheless, the fallout from the financial crisis may be impacting the long-term performance of value stock indexes.

Posted by Eddy Elfenbein on November 6th, 2015 at 11:17 am

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.