One of the great debates in finance is whether the source of the value premium is risk-based or a behavioral anomaly. In our book, “Your Complete Guide to Factor-Based Investing,” my co-author Andrew Berkin and I present the evidence showing that there are good arguments on both sides. Thus, it’s likely the answer isn’t black or white. For example, we show that the academic research demonstrates that value firms not only have poorer earnings and profitability compared to growth firms, but their greater leverage and more irreversible capital increases their risks in times of financial distress.(1) Stocks that do poorly in bad times should command large risk premiums. Thus, investors demand a higher return on value stocks than on growth stocks as compensation for higher vulnerability due to financial distress. With that said, the literature provides us with several behavioral explanations for the value premium.

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One such explanation is that investors are systematically too optimistic in their expectations for the performance of growth companies and too pessimistic in their expectations for value companies. Ultimately, prices correct when expectations are not met. An early well-known study of this reasoning is the 1994 paper “Contrarian Investment, Extrapolation, and Risk” by Josef Lakonishok, Andrei Shleifer and Robert W. Vishny.(2)Another behavioral explanation is that investors confuse familiarity with safety. Because they tend to be more familiar with popular growth stocks, those stocks tend to be overvalued.

Piostroski and So Tackle the Risk Versus Mispricing Debate

Joseph D. Piotroski and Eric C. So, authors of the 2012 study “Identifying Expectation Errors in Value/Glamour Strategies: A Fundamental Analysis Approach,” which covered the period from 1972 through 2010, tested the mispricing hypothesis by identifying potential ex-ante biases and comparing expectations implied by pricing multiples against the strength of firms’ fundamentals. Value strategies would be successful if prices do not accurately reflect the future cash flow implications of historical information in a timely manner, resulting in equity prices that temporarily drift away from their fundamental values.

Piotroski and So classified and allocated observations into value and glamour (growth) portfolios on the basis of each firm’s book-to-market (BtM) ratio. A firm’s BtM ratio reflects the market’s expectations about future performance. Firms with higher expectations will have higher prices and a lower BtM ratio, while, conversely, firms with weak expectations will have lower prices and a higher BtM ratio. Thus, the book-to-market ratio serves as a proxy for the relative strength of the market’s expectations about a firm’s future performance.

The authors classified a firm’s recent financial strength by utilizing the aggregate statistic FSCORE, which is based on nine financial signals designed to measure three different dimensions of a firm’s financial condition: profitability, change in financial leverage/liquidity, and change in operational efficiency. The FSCORE is an early example of a composite quality factor (such as the QMJ, or quality minus junk, developed by researchers at AQR Capital Management).(3) Firms with the poorest signals have the greatest deterioration in fundamentals and are classified as low FSCORE firms. Firms receiving the highest score have the greatest improvement in fundamentals and are classified as high FSCORE firms. Prior research had demonstrated that the FSCORE is positively correlated with future earnings growth and future profitability levels. Low FSCORE firms experience continued deterioration in future profitability and high FSCORE firms experience overall improvement in profitability.

The following is a summary of Piotroski and So’s findings:

  • Among firms where the expectations implied by their current value/glamour classification were consistent with the strength of their fundamentals, the value/glamour effect in realized returns is statistically and economically indistinguishable from zero.
  • The returns to traditional value/glamour strategies are concentrated among those firms where the expectations implied by their current value/glamour classification are incongruent ex-ante with the strength of their fundamentals.
  • Returns to this “incongruent value/glamour strategy” are robust and significantly larger than the average return generated by a traditional value/glamour strategy.

In the academic literature, the explanation for the mispricing of value stocks relative to growth stocks is that behavioral errors, such as optimism, anchoring and confirmation biases, cause investors to underweight or ignore contrarian information. As Piotroski and So noted:

Investors in glamour stocks are likely to under-react to information that contradict their beliefs about firms’ growth prospects or reflect the effects of mean reversion in performance. Similarly, value stocks, being inherently more distressed than glamour stocks, tend to be neglected by investors; as a result, performance expectations for value firms may be too pessimistic and reflect improvements in fundamentals too slowly.

Piotroski and So’s findings were consistent with the mispricing explanations for the value premium. They found that the value/glamour effect was concentrated among the subset of firms for which expectations implied by book-to-market ratios were not aligned with the strength of the firms’ fundamentals (FSCORE). And, more importantly, the value/glamour effect was nonexistent among firms for which expectations in price were aligned with the strength of the firm’s recent fundamentals. They concluded that firms with low book-to-market ratios and low FSCOREs (weak fundamentals) were persistently overvalued, and firms with high book-to-market ratios and high FSCOREs (strong fundamentals) were persistently undervalued. It was in these subsets that the pricing errors were strongest. The authors also noted that while both the traditional value/glamour strategy (relying solely on BtM rankings) and the incongruent value/glamour strategy produce consistently positive annual returns, the frequency of positive returns was higher for the incongruent value/glamour strategy. It generated positive returns in 35 out of 39 years over the sample period (versus 27 out of 39 years for the traditional value/glamour strategy). They also found that annual returns to the incongruent value/glamour strategy were larger than the traditional value/glamour strategy in all but six years, with an average annual portfolio return of 20.8 percent versus 10.5 percent for the traditional value/glamour strategy.

The figure below highlights the key result from Piotroski and So. The incongruent, or high predicted mispricing portfolio, has strong performance, whereas the congruent, or low predicted mispricing portfolio, has weaker performance.

Value Premium
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Piotroski and So’s findings are supported by those of H.J. Turtle and Kainan Wang, authors of the study “The Value in Fundamental Accounting Information,” which appears in the Spring 2017 issue of the Journal of Financial Research. Using Piotroski’s FSCORE, they examined the role of fundamental accounting information in shaping portfolio performance. Their data set covers the period from 1972 through 2012. Providing support for the behavioral-based explanations as a source of the value premium, they showed that portfolios of firms with strong fundamental underpinnings generated significant positive performance after controlling for the factors of market beta, size (SMB, small minus big), value (HML, high minus low), momentum (MOM), investment (CMA, conservative minus aggressive), and profitability (RMW, robust minus weak). They noted that their results “suggest that the abnormal gains from a strategy based on underreaction to fundamental value changes under information uncertainty are not subsumed by common risk factors documented in the literature.”

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