Value Premium - Term Paper Example

 Value premium Introduction: Value Premium is of interest to investors because it helps them to assess whether their investments should be directed into value stocks or growth stocks. Dhatt et al (1999) have investigated the value premium for small cap stocks on the basis of greatest value through profits generated. They took into consideration profits accrued on the basis of price-to-earnings, price-to-sales as well as market to book ratios and found that value stocks consistently outperformed growth stocks and had lower standard deviations and coefficients of variation as compared to value stocks. They point out that research evidence which suggests that value premium is more significant than size effect, however it may not be the most efficient measure of value. Small stocks may be riskier and are likely to yield higher returns. Value assets are defined as those with a lower liquidating or intrinsic value as compared to their market value (O’Shaughnessy 1998:2) Value stocks are those with a higher book to market value and are thus riskier than growth stocks which have a high market value, although value stocks are expected to yield higher returns. Studies have demonstrated that a short term growth strategy has outperformed the market (Levis and Liodakis, 2001) although others contend that such out performance is only the result of the higher risk factor and that growth stocks may actually outperform value based stocks in the long run (Beneda 2002). Where value stocks are concerned, the potential for returns exists in the future; therefore their book returns may be lower. However in the case of stocks known as growth stocks where the book value is higher than the market value, the short term returns are higher but the beta value obtained through the Capital asset Pricing Model may not be higher than that for value stocks. The reason for this phenomenon is because the CAPM beta is a relative measure of stock value, which also factors in time. Therefore from this perspective, the growth stocks may provide more value in the short term, however from the long term point of view they may in fact reflect a losing trend because these are the firms that are viewed in the market as potential loss firms, and therefore have a lower value as compared to the riskier value stocks, which may however have enormous potential for high returns after some years. Applying the CAPM Model, value investment styles outperform the market because they are riskier, a position that has been supported by Gulen and Vassalou (2001) who have linked variations in value premium occurring over time to variables such as the future Gross Domestic Product that reflect the macroeconomic risks in the market. However, Lakonishok, Shleifer and Vishny (1994) have suggested that the future growth rates of growth stocks are generally over estimated because investors rely on information on the stocks from the recent past, which does not provide a rational indication of future price. A neural network model was used in the Singapore stock exchange by Phua et al (2001). This neural network was used in an attempt to try and predict market direction in the Singapore Stock Exchange Straits Times Index. The authors of the study were able to achieve an 81% accuracy in their predictions about market direction, although the model could not pick up price reversals. Such neural networks are particularly useful in accurately identifying trends in long term markets such as real estate, since property trust units behave in a very similar manner to stocks during the short term period and are quite unlike direct property (Webb, Seiler and Meyer 1999). Such models can therefore help to identify value based stocks which in the long run have been found to outperform the market. Value premium in the United States vis a vis other countries. Patro (2005) carried out a study of stock market liberalization in emerging markets and the impact upon the emerging market country fund premiums, share prices and the values of net assets. Based upon his analysis of the results when new country funds are listed in the international markets, he concluded that there was an 8.8% decrease in the value premiums of the old funds during the first four months after which the new funds were announced. Moreover, he found that while liberalization and the opening up of the markets has a positive impact upon the net asset values, it does not have an effect on the value premiums. As the author points out in his study, this may be because while an economy is not yet opened up to international investors due to political restrictions, there is a greater element of risk involved in investment, therefore the securities are priced lower than they would be in a situation where risk sharing takes place with world capital, consequently value premiums may be higher and decline once these markets are opened up. Garza Gomez (2001) has undertaken a study of the correlation between the risk and market value of equity. He points out that the spread in returns between value stocks and growth stocks is very significant in the United States, both from a statistical and economic point of view and this trend is also noticed in other non U.S. countries. He has also highlighted the views of experts that have suggested two major reasons for the value premium. The first of these is the risk proxy idea which has been supported by Fama and French (1993, 1995, 1996, 1998) through a three factor model, which suggests that value stocks are more risky and therefore higher returns will be required. On this basis, the market value of equity (MVE) and the ratio of book value to market value of equity (BV/MV) are the proxies for two risk factors. The other school of thought is that mooted by Lakonishok, Shleifer and Vishny (1994) whereby the pattern of investing as practiced by institutional investors tends to focus on the short term potential of the stocks through recent activity in the market rather than making prediction about potential long term price of the stocks. Garza Gomez (2001) undertook a study of Berk’s (1995) discounted cash flow model, which is based on the premise that the market value is associated with risk through the discount rate in order to test out existing studies carried out in Japan using the model which showed that among companies of a similar physical size, those with low market values have more risky cash flows than those with high market values. The Companies tested were those that belonged in the Japanese stock market and had a positive book value of equity. However, contrary to the views of Fama and others who offer risk based explanations for value premium, this study showed that the value premium may be conditioned differently: (a) market value could correlate with variables other than risk, thereby questioning the adequacy of risk based explanations for value premium (b) the ratio of Book Value to Market Value challenges traditional risk factor models that include stock prices and (c) The variable of book value may need revision, since it reflects a level of financial risk that is beyond its natural association with cash flows. In offering an explanation for the differing value premiums and the inadequacy of traditional models used in the United States to explain the phenomenon in Japan could be the result of the differing economic environment in the U.S. where individual investors play a stronger role than in Japan. Moreover, due to differences in the accounting practices that are used in Japan, the Japanese companies post lower earnings. Therefore, the differences in value premiums could largely be a function of the differences in the two markets. Macedo (1999) examined the factors affecting premium in different countries and has highlighted the fact that different countries show different investment styles. The factors that could condition investment styles and therefore resulting value premiums will depend upon the potential for earnings growth since undervalued markets or markets likely to experience strong economic growth are likely to yield the kind of undervalued stocks with high prospective earnings growth. Moreover, differences in the volatility of the markets in different countries will also provide an indication of investment styles and value premium. For instance, after a period of high volatility in the market, growth stocks tend to outperform value stocks, while leveraged stocks do well and small cap stocks perform better than large cap stocks. During periods of market volatility, there is a higher value premium, because of the element of risk that must be borne. Macedo (1999) has highlighted the importance of the economic climate prevailing in each country as being an important factor in determining levels of risk and investment patterns, which also helps to explain why value premium may not necessarily follow the same patterns as it does in the United States where the number of independent investors is higher. A strong value premium was found in the U.K. by Dimson et al (2003). They pointed out that value stocks appear to enjoy a high premium in many markets in the world, similar to the United States. Using the radio of Book-value-to-equity and Market-Value-of-Equity (BE/ME) as the determining factor is arriving at value, the authors discovered there was a strong value premium that existed in the United Kingdom for the period from 1995-2001, with an especially strong value premium among small cap stocks. However, they also discovered that strategies implemented in order to capture value premium within the small cap segment is a costly exercise. This highlighted one aspect of the differences between the UK and US markets, since trading costs are an important element in the UK which significantly impact upon investor decisions. As a result, investors within the UK must factor in trading costs while assessing the prospective returns from stocks, especially when they are involved in a phase of active trading where short term returns are more important. While trading costs are also substantially higher where small cap stocks are concerned, as compared to the large cap stocks, the problem of trading costs is a much more severe one in the UK as compared to the United States and has a more substantial impact upon the decisions of investors, thereby correspondingly affecting value premiums as well. In carrying out their analysis, Dimson et al (2003) used different sizes and BE/ME breakpoints from those set by Fama and French, based upon the New York Stock Exchange, i.e, 50 percent ME and a 30:70 percent BE/ME. The reasons why the authors set these different points was that firstly, in the United Kingdom, size and value are negatively correlated while they are positively correlated in the United States. Therefore in the analysis carried out by Dimson et al (2003), the small cap stocks are concentrated in the high BE/ME range while the large cap stocks are aggregated in the low BE/ME range. The range for the small cap stocks used by Dimson et al (2003) was higher, with small cap portfolios covering about 6 percent of the aggregate market cap. As a result, the ultimate result that was obtained was a distribution similar tot hat generated by Fama and French, where most of the Nasdaq stocks tend to be grouped into the small cap segment range. Conclusions: On the basis of the above, it may therefore be concluded that the value premium is by no means a localized phenomenon pertaining only to the United States, rather it exists in other countries as well, although there may be substantial differences depending upon conditions in different countries and whether the economy is an emerging one. Cooper, Gulen and Vassalou (2001) have used information about a particular country’s economy as a means to relate the fundamental risk in the economy to value sorted portfolios. However, Black et al (2007) consider linkage of the value premium price index across the G7 countries and found a definite correlation among these countries. Their results appear to suggest that the value premium index is a wealth index, which measures long term value, therefore macroeconomic risks as well the potential that exists for future growth must be taken into consideration and such potential is likely to be higher in the G7 countries, as opposed to the emerging economies, where there is a higher level of risk associated with the investment. Chen et al (2002) point out that increasing trends in economic integration among different countries of the world, such as the European Union, may also serve to explain why there may be a significant long run relationship between stock prices of different countries. 2094 words References: * Beneda, N. (2002). “Growth Stocks Outperform Value Stock Over the Long Term” Journal of Asset Management, 3(2), pp 112-23. * Berk, Jonathan B. 1995. 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