Understanding The Value Premium

Historically, value stocks have outperformed growth stocks. The evidence is persistent and pervasive, both around the globe and across asset classes. While there’s no debate about the premium, there are two competing theories to explain its existence.

The Classic Theory

The theory from classical financial economics is that value stocks are the equities of riskier companies. Their prices co-move with some risk factor, be it distress, liquidity or the “black swan” risk of an extremely negative economic event.

Finance professors Eugene Fama and Kenneth French constructed a proxy for this risk factor. Their HmL (high minus low) factor (the return of stocks with high book-to-market values minus the return of stocks with low book-to-market values) can be used to assess a stock’s sensitivity to this yet-to-be-identified source of risk in the economy. Value stocks have high HmL loadings and, therefore, are expected to deliver high average returns as risk compensation.

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