It’s not easy to be a value investor.
Between 60 percent and 80 percent of the time, the value premium “either does not exist or [is] very low,” according to a recent study analyzing value performance between 1968 and 2018.
It’s only after the overall market becomes either highly overvalued or deeply undervalued that the value premium really materializes, found Tilburg University professor Stefano Casella, Zhaojing Chen and Huseyin Gulen of Purdue University, and Case Western Reserve University’s Ralitsa Petkova.
The researchers theorized that value returns are driven mainly by what they call extrapolators — investors who buy stocks based on the belief that markets will keep going up, or sell because they believe markets will keep going down.
“As return extrapolators are drawn into the market, they not only amplify the initial price jump of equities (causing overvaluation and eventual poor performance of the market), but furthermore, they invest in stocks with relatively more positive cash-flow shocks and higher returns,” the authors wrote.
In other words, these market-chasing investors favor growth stocks, increasing the valuation gap between these high-flyers and stocks with lower or negative cash-flow shocks — the value stocks. It’s the eventual correction of these mispricings that results in the value premium.
A similar phenomenon occurs when stocks, on average, are experiencing negative shocks: Extrapolators disproportionately sell poor-performing value stocks, causing them to become “extremely” undervalued. Again, the value premium is realized when these valuations are corrected.
“Our main premise is that when people are excited about stocks in general, they are particularly excited about growth stocks; and when they are depressed about the stock market, they are particularly depressed about value stocks,” the researchers explained.
Using a collection of surveys that track investor sentiment about the market, the co-authors found that value premiums were highest after the periods in which extrapolators reported extremely positive or negative market expectations. Specifically, they found that the monthly value premium was 1.5 percent after periods of extreme optimism, and 3.5 percent after extreme pessimism.
“When there is no significant market-wide misvaluation and extrapolative expectations are not extreme, the value premium is not statistically different from zero,” they said.
Based on their findings, the researchers suggested there are “quantifiable benefits” to timing exposures to value stocks based on overall market valuations.
“A strategy that implements value-minus-growth following periods of market-wide misvaluation and holds the market portfolio otherwise results in higher mean return and lower volatility than the unconditional value-minus-growth strategy,” they said.