The Value Premium Puzzle

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4th Value Investor Conference
Los Angeles, 8th of May 2007

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The Value Premium Puzzle

  1. 1. The value premium puzzle Alexis Eisenhofer ATACAMA Capital 4th Value Investor Conference Los Angeles, 8th of May 2007 Alexis Eisenhofer The value premium puzzle 1/29
  2. 2. Empirical evidence: The value premium The puzzle: The contradiction to the CAPM Solutions: A review of the literature ConclusionTable of contents Empirical evidence: The value premium The puzzle: The contradiction to the CAPM Solutions: A review of the literature Conclusion Alexis Eisenhofer The value premium puzzle 2/29
  3. 3. Empirical evidence: The value premium The puzzle: The contradiction to the CAPM Solutions: A review of the literature ConclusionTable of contents Empirical evidence: The value premium The puzzle: The contradiction to the CAPM Solutions: A review of the literature Conclusion Alexis Eisenhofer The value premium puzzle 3/29
  4. 4. Empirical evidence: The value premium The puzzle: The contradiction to the CAPM Solutions: A review of the literature ConclusionInvestment 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 Value Low PE; high BtM Low PE; high BtM Low PE; high BtM High DivYld High DivYld High DivYld MCAP < 1 bln. USD 10 bln. USD ≥ MCAP ≥ 1 bln. USD MCAP > 10 bln. USD Growth High PE; low BtM High PE; low BtM High PE; low BtM Low 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 1 Basu (1977), Banz (1981), Fama/French (1992) Alexis Eisenhofer The value premium puzzle 4/29
  5. 5. Empirical evidence: The value premium The puzzle: The contradiction to the CAPM Solutions: A review of the literature ConclusionThe value premium: In the long run value outperformsgrowth (and small stocks outperform large stocks) Alexis Eisenhofer The value premium puzzle 5/29
  6. 6. Empirical evidence: The value premium The puzzle: The contradiction to the CAPM Solutions: A review of the literature ConclusionGrowth stocks only outperformed value stocks in times ofstock market bubbles Alexis Eisenhofer The value premium puzzle 6/29
  7. 7. Empirical evidence: The value premium The puzzle: The contradiction to the CAPM Solutions: A review of the literature ConclusionThe one-year growth and value trend is quite volatile... Alexis Eisenhofer The value premium puzzle 7/29
  8. 8. Empirical evidence: The value premium The puzzle: The contradiction to the CAPM Solutions: A review of the literature Conclusion...but becomes more apparent with a longer (e.g.three-year) time horizon Alexis Eisenhofer The value premium puzzle 8/29
  9. 9. Empirical evidence: The value premium The puzzle: The contradiction to the CAPM Solutions: A review of the literature ConclusionThe value premium has been seen in many countries but... Alexis Eisenhofer The value premium puzzle 9/29
  10. 10. Empirical evidence: The value premium The puzzle: The contradiction to the CAPM Solutions: A review of the literature Conclusion...the magnitude of the value premium differs very muchacross countries Alexis Eisenhofer The value premium puzzle 10/29
  11. 11. Empirical evidence: The value premium The puzzle: The contradiction to the CAPM Solutions: A review of the literature ConclusionLow correlations indicate that there are no simultaneous”value phases” across all countries Alexis Eisenhofer The value premium puzzle 11/29
  12. 12. Empirical evidence: The value premium The puzzle: The contradiction to the CAPM Solutions: A review of the literature ConclusionTable of contents Empirical evidence: The value premium The puzzle: The contradiction to the CAPM Solutions: A review of the literature Conclusion Alexis Eisenhofer The value premium puzzle 12/29
  13. 13. Empirical evidence: The value premium The puzzle: The contradiction to the CAPM Solutions: A review of the literature ConclusionThe capital asset pricing model postulates a direct relationbetween expected return and systematic risk2 Capital asset pricing model Reward-to-risk ratio µi 6 µi = rf + (µm − rf ) · βi (1) Security market line Cov (ri ; rm ) q µm m βi = 2 (2) σm rf rf := Risk-free rate; µm := Expected return of the market; βi := Systematic risk of asset i; - βi βm = 1 2 Sharpe (1964) Alexis Eisenhofer The value premium puzzle 13/29
  14. 14. Empirical evidence: The value premium The puzzle: The contradiction to the CAPM Solutions: A review of the literature ConclusionEven though value stocks offered higher returns to theinvestor their risk was lower Alexis Eisenhofer The value premium puzzle 14/29
  15. 15. Empirical evidence: The value premium The puzzle: The contradiction to the CAPM Solutions: A review of the literature ConclusionThe drawdown of value stocks was lower while their upsidepotential was almost equal to growth stocks Alexis Eisenhofer The value premium puzzle 15/29
  16. 16. Empirical evidence: The value premium The puzzle: The contradiction to the CAPM Solutions: A review of the literature ConclusionThe assumptions of the CAPM are very simple and hardlyreflect real investor behavior Major CAPM assumptions... ...conflict with reality 1 All investors share the same ⇔ 1 Investors are not perfectly information and act rationally informed and are irrational 2 Returns are distributed ⇔ 2 Time varying nonsymmetric normally distributions 3 All investors hold the (same) ⇔ 3 Investors hold different market portfolio portfolios 4 Frictionless and efficient capital ⇔ 4 Transaction costs and markets inefficiencies Alexis Eisenhofer The value premium puzzle 16/29
  17. 17. Institutional imperative and overestimation Empirical evidence: The value premium Investor disagreement The puzzle: The contradiction to the CAPM A Duration-based explanation Solutions: A review of the literature Fixed-income hedging Conclusion Evolutionary finance Transaction costs and institutional ownershipTable of contents Empirical evidence: The value premium The puzzle: The contradiction to the CAPM Solutions: A review of the literature Conclusion Alexis Eisenhofer The value premium puzzle 17/29
  18. 18. Institutional imperative and overestimation Empirical evidence: The value premium Investor disagreement The puzzle: The contradiction to the CAPM A Duration-based explanation Solutions: A review of the literature Fixed-income hedging Conclusion Evolutionary finance Transaction costs and institutional ownershipThe value premium can be explained by emotions andcognitive errors of investors The institutional imperative (managers tend to act like their peers) leads to investments in ”glamor stocks”, even if their valuation is inferior to ”unknown” stocks3 Investors are too optimistic because they naively extrapolate earnings trends and stick too long to high growth rates4 Hope and fear drives overvaluation (undervaluation) of growth (value) 3 Buffett (1989) 4 DeBondt/Thaler (1987) Alexis Eisenhofer The value premium puzzle 18/29
  19. 19. Institutional imperative and overestimation Empirical evidence: The value premium Investor disagreement The puzzle: The contradiction to the CAPM A Duration-based explanation Solutions: A review of the literature Fixed-income hedging Conclusion Evolutionary finance Transaction costs and institutional ownershipValue stocks and small-cap stocks earn higher returnsbecause there is greater disagreement about the stocksfuture payoffs5 The divergence in analysts earnings forecasts is a proxy for investor disagreement Value stocks have a greater divergence of opinion than growth stocks Small-capitalization stocks exhibited greater forecast dispersion than stocks of large companies 5 Daniel/Titman (1997) Alexis Eisenhofer The value premium puzzle 19/29
  20. 20. Institutional imperative and overestimation Empirical evidence: The value premium Investor disagreement The puzzle: The contradiction to the CAPM A Duration-based explanation Solutions: A review of the literature Fixed-income hedging Conclusion Evolutionary finance Transaction costs and institutional ownershipGrowth companies have higher betas because of their highduration of cash flows while their low covariance to cashflow risk accounts for lower returns6 Risk is explained through cash flow risk and discount rate risk (Duration) Value stocks, as short-horizon equity, vary more with fluctuations in cash flows (⇒ lower Duration); Growth stocks, as long-horizon equity, vary more with fluctuations in discount rates (⇒ higher Duration) Investors fear cash flow risk far more than discount rate risk which is why value investors claim a premium on their investment 6 Lettau/Wachter (2005) Alexis Eisenhofer The value premium puzzle 20/29
  21. 21. Institutional imperative and overestimation Empirical evidence: The value premium Investor disagreement The puzzle: The contradiction to the CAPM A Duration-based explanation Solutions: A review of the literature Fixed-income hedging Conclusion Evolutionary finance Transaction costs and institutional ownershipThe value premium can be explained as an insurance forinstitutional investors because growth stocks offer a goodhedge against fixed-income risk7 Value stocks with constant dividends are similar to fixed-income instruments such as bills, bonds and loans Institutional investors such as life-insurance companies, banks and pension funds typically invest heavily in fixed-income instruments Despite the sizeable premium for value stocks, growth stocks are attractive to these investors because they offer a good hedge against fixed-income risk 7 Post/Van Vliet (2006) Alexis Eisenhofer The value premium puzzle 21/29
  22. 22. Institutional imperative and overestimation Empirical evidence: The value premium Investor disagreement The puzzle: The contradiction to the CAPM A Duration-based explanation Solutions: A review of the literature Fixed-income hedging Conclusion Evolutionary finance Transaction costs and institutional ownershipThe value strategy dominates a growth, momentum orglamor portfolio in the long run due to the convergence ofmarkets towards fundamental values8 A Darwinian approach: The market as a heterogeneous population of portfolio strategies in competition for market capital The value strategy wins because markets tend to converge towards fundamental values This convergence property gives rise to a predictability of asset returns based on fundamental criteria 8 Hens/Schenk-Hopp´/Woehrmann (2006) e Alexis Eisenhofer The value premium puzzle 22/29
  23. 23. Institutional imperative and overestimation Empirical evidence: The value premium Investor disagreement The puzzle: The contradiction to the CAPM A Duration-based explanation Solutions: A review of the literature Fixed-income hedging Conclusion Evolutionary finance Transaction costs and institutional ownershipThe value premium persists because of marketimperfections and is negatively correlated with the degreeof institutional ownership9 The value premium can persist because transaction costs and short selling constraints keep away arbitrage trades Institutional investors are better informed of the value premium and have a better market access to profit from value mispricings Companies with larger institutional ownership (typically larger companies) carry a smaller value premium 9 Phalippou (2004) Alexis Eisenhofer The value premium puzzle 23/29
  24. 24. Empirical evidence: The value premium The puzzle: The contradiction to the CAPM Bibliography Solutions: A review of the literature Contact ConclusionTable of contents Empirical evidence: The value premium The puzzle: The contradiction to the CAPM Solutions: A review of the literature Conclusion Alexis Eisenhofer The value premium puzzle 24/29
  25. 25. Empirical evidence: The value premium The puzzle: The contradiction to the CAPM Bibliography Solutions: A review of the literature Contact ConclusionValue investing is a superior investment style in the longrun The value premium has been seen for many years and will probably persist in the future Small cap stocks show a higher premium than large caps The correlation of the value premium in different countries is low Behavioral rather than rational aspects can ”solve” the puzzle Alexis Eisenhofer The value premium puzzle 25/29
  26. 26. Empirical evidence: The value premium The puzzle: The contradiction to the CAPM Bibliography Solutions: A review of the literature Contact ConclusionReferences * Banz, Rolf W. (1981): The relationship between return and market value of common stocks, Journal of Financial Economics 9, 3-18. * Basu, Sanjoy (1977): Investment performance of common stocks in relationship to their price-earnings ratios: A test of the efficient market 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 the characteristics of cross sectional variation in stock returns, Journal of Finance 52, 1-33. Alexis Eisenhofer The value premium puzzle 26/29
  27. 27. Empirical evidence: The value premium The puzzle: The contradiction to the CAPM Bibliography Solutions: A review of the literature Contact ConclusionReferences * DeBondt, Werner, and Richard Thaler (1985): Does the stock market overreact?, Journal of Finance 40, 793-805. * Fama, Eugene F., and Kenneth R. French (1992): The cross-section of expected stock returns, Journal of Finance 47, 427-465. * Hens, Thorsten, and Klaus Reiner Schenk-Hopp´, and Peter e Woehrmann (2006): An evolutionary explanation of the value premium puzzle, NCCR FINRISK Working Paper No. 280. * Lettau, Martin, and Jessica A. Wachter (2007): Why is long-horizon equity less risky? A Duration-based explanation of the value premium, Journal of Finance 62, 55-92. Alexis Eisenhofer The value premium puzzle 27/29
  28. 28. Empirical evidence: The value premium The puzzle: The contradiction to the CAPM Bibliography Solutions: A review of the literature Contact ConclusionReferences * Phalippou, Ludovic (2004): What drives the value premium, INSEAD Working Paper May 2004. * Post, Thierry, and Pim van Vliet (2006): Loss aversion and the value 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. Alexis Eisenhofer The value premium puzzle 28/29
  29. 29. Empirical evidence: The value premium The puzzle: The contradiction to the CAPM Bibliography Solutions: A review of the literature Contact ConclusionThank you for your attention! Dr. Alexis Eisenhofer Phone: +49-(0)89-2000320 ATACAMA Capital GmbH Fax: +49-(0)89-20003232 Maria-Probst-Str. 19 eMail: eisenhofer@atacap.com D-80939 Munich Web: http://www.atacap.com Germany This presentation will be available on the web site http://www.atacap.com/ Alexis Eisenhofer The value premium puzzle 29/29

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