What drives the value premium?
The empirical evidence for the presence of a value premium in stock markets is overwhelming. But why does this phenomenon exist? A new white paper examines a popular explanation.
Speed read:
- We examine a popular explanation called the overreaction hypothesis
- This hypothesis is based on the extrapolation of past sales or earnings growth
- It attributes the value premium to behavioral factors
- Generic value strategies cannot be enhanced significantly based on this hypothesis
- We conclude that the evidence supporting it is quite weak
Reasons why value premium exists are debated
Although there is by now a consensus that a strong value premium is present in the data, the reasons why this phenomenon exists are still heavily debated. In previous research we provided strong evidence against the distress risk explanation, showing that although simple value strategies can get a large exposure to distressed stocks, this does not explain the high return of value stocks.
More risk-based explanations have been proposed in the literature, but next to that there is also a school of thought which attributes the value premium to behavioral factors. In this white paper (download below) we examine one such behavioral explanation, namely the overreaction hypothesis.
According to this hypothesis, value stocks do show lower growth rates in subsequent years, and growth stocks do show higher subsequent growth rates, but not nearly as long and to the extent needed to justify the differences in valuation assigned to them by the market.
Little empirical support for overreaction hypothesis
We find that although overreaction indicators appear to be fairly promising on a stand-alone basis, they are not really effective for enhancing a generic value strategy. Moreover, if we disentangle the contribution to return of various factors, valuation is significant while the overreaction indicators are not.
This indicates that valuation ratios are really driving differences in future stock returns. Based on these findings we conclude that the empirical support for the overreaction hypothesis is quite weak.
