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The Value Effect

Discussion note 16 - 4 December 2012

In this note, we review the theory and empirical evidence of the value effect. The value effect is the excess return that a portfolio of value stocks (stocks with a low market value relative to fundamentals) has, on average, earned over a portfolio of growth stocks (stocks with a high market value relative to fundamentals). We will focus our attention in this note on the existence of a value effect in equity markets.

Main findings

  • The outperformance of value stocks over growth stocks was documented by Graham and Dodd in 1934 and has since received a great deal of attention in financial research. There has been a positive and statistically significant value effect across global equity markets, although the effect has varied significantly over time

  • Fama and French (1992) show that the Capital Asset Pricing Model (CAPM) fails to account for the value effect in historical data. Fama and French (1993) argue that one needs to employ a multifactor model in order to account for the cross-section of equity risk and return. Their multifactor asset-pricing model, which includes two empirically motivated risk factors that capture small-firm and value effects, has been widely adopted by academics and practitioners to better describe equity returns.

  • The value effect has since been documented to be robust across different measures of value and portfolio specifications. However, there is some evidence that the value effect has been higher in less liquid segments of the equity market, particularly during the most recent 20-year period. 

  • A number of rational explanations have been put forward to account for the empirical regularity. These theories attribute the value effect to risk factors such as firm distress, illiquidity or business cycle sensitivity.

  • A number of behavioural finance explanations argue that human cognitive biases may lead to asset mispricing. The most prominent are representativeness, conservatism and overconfidence, which all lead to investor over- and under-reaction and thereby the value effect.

  • A recent theoretical framework is where a stock‚Äôs expected rate of return depends on its sensitivity to cash-flow and discount-rate news. It is argued that a rational investor cares more about falling expectations of future cash flows since this unambiguously reduces investor wealth. An increasing discount rate does the same, but is partly offset by the higher expected return that comes with an increasing discount rate. The outperformance of value stocks is interpreted as compensation for the observation that value stocks are more sensitive to changes in expectations of future cash flows.

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