Is the value premium disappearing? The answer to that question could shake the foundations of the asset-management industry.
First, for the uninitiated, a little background. In the late 1970s and 1980s, a lot of investors and researchers confirmed what market analysts had claimed for a long time — that certain stocks seemed cheap relative to their value on paper. These stocks tended to perform better, on average, than the stock market as a whole. That was a bit of a puzzle, since basic finance theory says that it shouldn’t be that easy to beat the market. If you can just buy stocks that are cheap relative to their book value, and wait for them to go up, the market isn’t very efficient, is it?
To beat the market that easily and that consistently, the strategy should incur some kind of systematic risk — risk that you can’t get rid of with diversification.
In the early 1990s, future Nobel-winning finance researcher Eugene Fama and his longtime co-author Kenneth French came up with a partial answer to the puzzle. Some stocks, they said, were so-called value stocks that tended to trade at prices below their book values. During certain periods, these stocks all tend to rise in value, but other times they tend to all fall together. Over a long period of time, the rises outweigh the falls, so that these value stocks earn a premium. But if you invest in value stocks and you get caught in one of the bad periods, you’re in trouble. Hence the value premium persists, because trading against it — by simply loading up on all the value stocks you can grab — incurs some risk.
That answer wasn’t completely satisfying. Why do value stocks all tend to rise in certain periods and fall in others? One possibility, described here by asset-management mogul Cliff Asness, is that value stocks are “crappy companies.” Shaky companies might find themselves suddenly squeezed for credit under certain conditions, while other companies are still able to borrow. That might explain the value premium. But it turns out that the times when value underperforms and outperforms are not clearly tied to the business cycle. The mystery remains.
Fama and French’s model of a risk-based value premium has become standard throughout the asset-management industry. But there’s another, more disquieting possibility. It may be that the value premium is caused not by risk, but by systematic inefficiencies in the financial market.