What is the “Price” (Value) Factor?
Simply stated, a diversified basket of “value” stocks (i.e., stocks that possess a low relative valuation, as determined by price-earnings, price-book, price-sales, and/or or price-to-free cash flow ratios) possesses a very high probability of outperforming a diversified basket of “growth” stocks (i.e., stocks that possess high relative valuations, by the same measures) over any long period (20 years or longer) of time.
How Strong is the Value Factor?
By looking at the average annualized returns from April 1, 1993 through April 30, 2023 (a 30-year period), we see evidence of the value factor, particularly among small company U.S. stocks:
Average Annualized Returns Growth of $1.00
S&P 500 Index (large company U.S. stocks): 9.78% $16.57
DFA U.S. Large Cap Value Portfolio: 9.66% $15.99
DFA U.S. Small Cap Portfolio: 9.87% $16.96
DFA U.S. Small Cap Value Portfolio: 10.90% $22.46
Source: DFA ReturnsWeb, using returns information from Standard & Poors and Dimensional Funds Advisors. Past performance is not a guarantee of future returns. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index.
A study for the period from January 1992 through June 2017 examined the price factor using quintiles, while also breaking the data set by size. The average excess monthly returns are then shown:
| Growth Value | |||||
| 1 | 2 | 3 | 4 | 5 | |
| Small | 0.21% | 0.92% | 0.97% | 1.15% | 1.20% |
| 2 | 0.61% | 0.87% | 0.91% | 0.94% | 0.98% |
| 3 | 0.59% | 0.89% | 0.89% | 0.92% | 1.13% |
| 4 | 0.78% | 0.88% | 0.79% | 0.95% | 0.78% |
| Large | 0.61% | 0.74% | 0.77% | 0.47% | 0.83% |
Source: Tim Mooney, “Size and Book-to-Market: Comparing Factor Loadings, Characteristics, Methodologies, and Time Periods,” utilizing stock return date from CRSP for stocks listed on the NYSE, NASDAQ, and AMEX, excluding financial firms, utilities, ADRs, closed-end funds, preferred stocks, REITs, and stocks with a price of less than $1. Book value data obtained from Compustat. Data is for the period January 1992 through June 2017. Past performance is not a guarantee of future returns. The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index.
Reasons behind the Value Factor
There are several risk-based explanations for the price factor (also called “value risk premium”) (i.e., because of the greater risk of value stocks, greater returns exist):
- Value stocks are often found in companies often possess more debt. Companies with more debt find it harder to meet their obligations during recessions.
- Value stocks are sometimes in companies that are already in financial distress.
- Value stocks may face more earnings risk, than growth stocks.
- Value stocks are often found in companies that have larger amounts of assets to enable production. During economic recessions, this can result in nonproductive assets, which drags upon returns.
- Even on a diversified basis, value stocks (as an asset class) tend to fall further in value than growth stocks during major economic downturns.
There are several explanations for the price factor offered by the field of behavioral finance:
- Investors naively extrapolate past growth when evaluating a company’s stock, and thus overreact to that information, resulting in a situation where the stock gets overpriced.
- Investors tend to overreact to good news about a company, often causing the stock price of a growth stock to exceed its intrinsic value.
- Investors tend to overreact to bad news about a company, often causing the stock price of a value stock to be less than its intrinsic value.
A Probability of Higher Expected Returns Over the Long Term
It is important to note that the price (value) factor is not a guaranteed source of higher returns. However, it is fair to say that a highly diversified basket of value stocks possesses, over any given 20-year period of time, a substantial probability of outperforming the overall stock market (as may be represented by a total stock market index fund).
Dr. Ron A. Rhoades serves as Associate Professor of Finance and Director of the Personal Financial Planning Program within the Gordon Ford College of Business at Western Kentucky University. He teaches and has taught courses in Retirement Planning, Applied Investments, Advanced Investments, Estate Planning, Financial Plan Development, Personal Finance, Money & Banking, Risk Management and Insurance, and Principles of Finance. He is regarded as a national expert in the application of fiduciary duties to the delivery of investment and financial planning advice. Ron’s upcoming book, Mastering the Science and Art of Investing: Strategies for Maximizing Returns with Multi-Factor Portfolios, is due to be published later in 2023.
If you are interested in becoming a client of Ron’s firm, Scholar Financial, LLC, please view the “For Prospective Clients” page of this web site. Thank you!