Risk is a really tricky concept to get your hands around. We all kind of intuitively understand it—at least intellectually—but actually dealing with it can be tough. Unfortunately, dealing with risk is pretty much the entirety of finance.
One of the first steps in dealing with risk is to see what that risk looks like and why you actually want it in your portfolio.
We always start from the premise that risk and return are related. You cannot get higher returns without taking on more risk. But you need to take the right types of risk—the market only pays you for certain risk. One of those risks is value risk (a.k.a relative price risk).
What is Value Risk?
At its heart, value risk is the market saying there is something about a company that it doesn’t like. We can measure this by looking at the ratio between a company’s book value (what the accountants say a company is worth) versus its market value (what the markets say it’s worth). The bigger this number is, the more value risk a company has. To get an idea of how this works, let’s take a look at an example.
Company ABC
Company DEF
Book Value
$20 Billion
$20 Billion
Market Value
$25 Billion
$70 Billion
Book / Market Ratio
1.25
3.5
Looking at the numbers, it’s pretty clear that the markets like Company DEF a whole lot more than ABC. Investors are willing to pay almost three times the amount for the value (and associated future cash flows) of Company DEF than they are for Company ABC. We don’t necessarily know why the market doesn’t like Company ABC, but that doesn’t actually matter.
It feels really strange to say that the source of a company’s risk doesn’t matter, so let’s step back for a second. The market (basically) prices a company based on the discounted value of its expected future cash flows to investors—all of the dividends it will pay until it goes out of business discounted back to today.
This looks a little complicated, but it basically just says that the price of a security is based on today’s value of what the future cash flows will look like. The Required Return discounting term includes the uncertainty around what the cash flow amounts will be, as well as the normal time value of money.
This goes for traditional big blue chip companies that have paid dividends back to the 1800s, but also the high-flying tech companies that have never paid a dividend before. Presumably those tech companies will start paying dividends at some point, and all of the growth before then just means those dividends will be bigger.
So when we see two companies that look reasonably similar from an operations standpoint—similar sales, similar cost structure, similar prospects, etc.—but they don’t have the same market value, then the required (or expected) return for the companies is different. In other words, value companies have a higher expected return.
But it’s important to remember that this increased expected return comes from real risk. That means we won’t see this higher expected return every year, and there will be long periods where value underperforms growth. So let’s dive in to understand how the value premium has performed through time.
Performance of the Value Premium
When we look at the value premium, we want to isolate how much better (or worse) value stocks have done compared to growth stocks. There are all sorts of ways of getting at this, but we’ll keep it simple. For us, the value premium is simply the returns of value stocks minus the returns of growth stocks.
To set the stage, the average annual value premium was 4.81% per year, with a standard deviation of 16.37% from 1928 through the end of 2015. So we expect value stocks to outperform growth stocks by almost 5% per year, but there is a ton of variance around this.
Information provided by Dimensional Fund Advisors LP. In US dollars. The relative price premium is the Fama/French US Value Index minus the Fama/French US Growth Index. Fama/French indices provided by Ken French. Index descriptions available upon request. Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP. Ken French is also my father.
As we can see from the chart, the annual premiums are all over the place. Interestingly, they are pretty much everywhere but near the average premium. Out of the eighty-eight years of data we’re looking at here, only eleven years were within two percentage points of the average.
But as you can see from just looking at the chart, most years had positive value premiums. Turns out, almost two out of every three years had a positive value premium (the annual premium was positive 61.36% of the time).
This is great, but we don’t really think about investing over one-year time horizons. We want to see how it does over longer time periods. What does the value premium look like over longer time frames?
Rolling 5-Year Value Premiums 1932 – 2015
Information provided by Dimensional Fund Advisors LP. In US dollars. The five-year rolling relative price premium is computed as the five-year annualized compound return on the Fama/French US Value Index minus the five-year annualized compound return on the Fama/French US Growth Index. Fama/French indices provided by Ken French. Index descriptions available upon request. Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP.
Looking at the value premium over rolling five-year premiums, the big thing to notice is that there is a lot more blue and a lot less red. Three quarters (exactly 75%) of the five-year rolling periods from 1932-2015 had positive annualized premiums.
And, as you would expect from a longer time period, the premiums were smoothed out. The worst one-year value premium was in 1999, when growth stocks outperformed value by 27.57%.
When we look at a five-year window, the late ’90s were still the worst period for value, but value stocks only (only!) underperformed growth by 11.45% per year. For comparison, the latest five-year period (2011 – 2015) was certainly bad, but the annualized underperformance was only 3.52% per year.
If we look at ten-year periods, things get even smoother.
Rolling 10-Year Value Premiums 1937 – 2015
Information provided by Dimensional Fund Advisors LP. In US dollars. The 10-year rolling relative price premium is computed as the 10-year annualized compound return on the Fama/French US Value Index minus the 10-year annualized compound return on the Fama/French US Growth Index. Fama/French indices provided by Ken French. Index descriptions available upon request. Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP.
We see even more blue, and only a few periods where the value premium was negative over the ten-year window. In fact, 88% of the periods had a positive value premium.
And the negative periods got smoothed out even more (again, as we would expect). The period from 1990-1999 was the worst ten-year period for value, but growth stocks only outperformed value by 5.01% per year (the late ’90s were really bad for value).
Unfortunately, the period ending in 2015 (2006 – 2015) was one of the few ten-year periods with a negative premium. In fact, it was the third worst ten-year period for value ever, with growth stocks outperforming value by 2.96% per year.
Rolling 10-Year Value Premiums Sorted from Lowest to Highest 1937 – 2015
Information provided by Dimensional Fund Advisors LP. In US dollars. The 10-year rolling relative price premium is computed as the 10-year annualized compound return on the Fama/French US Value Index minus the 10-year annualized compound return on the Fama/French US Growth Index. Fama/French indices provided by Ken French. Index descriptions available upon request. Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP.
While the previous ten years have not been fun for value investors, it’s important to keep things in context. The past ten years have comprised the third worst period for the value premium ever. There were a couple bright spots over the period (2006, 2012, and 2013 all had positive value premiums), but we had a pretty good string of negative premiums.
While it’s easy to get discouraged and think that something has changed and the value premium doesn’t “work” anymore, keep in mind that each year’s premium is a random draw. Each year is independent, and what happened last year has no influence on what will happen this year. In fact, at least through the end of July, it’s looking to be a pretty good year for value.
The Fama/French indices aren’t available through the end of July, but using the Russell 3000 Value and Growth indices, the annualized value premium from January through July is 6.36%. This isn’t directly comparable to the numbers we’ve been looking at throughout the article, it’s fair to say that 2016 has been a good year for value so far.
This is why discipline is so important. Value stocks have been out of favor recently, but that’s going to happen. It wouldn’t be risk otherwise. If you didn’t lose money on a risk factor occasionally, there would be no reason for the market to provide higher returns over the long term.
It’s important to remember that the long term is what we need to focus on. If you want to harvest the higher returns that the value premium offers, you need to be prepared to deal with the periods where it will underperform growth.
We’ve been in one of those periods recently (though hopefully we’re coming out of it). But the underlying logic hasn’t changed. When the market doesn’t like a company, investors will demand a higher expected return to hold shares of that company. This higher expected return is the value premium.
**Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results.
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