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Value Premium as Risk Compensation

| | Posted in: Fundamental Valuation, Size Effect, Value Premium

Are value stocks priced low because the companies are in financial distress? In their May 2011 paper entitled “Is the Value Premium Really a Compensation for Distress Risk?”, Wilma de Groot and Joop Huij investigate the relationships between the value premium and alternative measures of firm distress risk. Their core methodology employs monthly double-sorts on firm book-to-market ratio and each of four measures of firm financial risk: (1) financial leverage (debt-to-assets ratio); (2) a structural model of distance-to-default; (3) credit spread (between firm bonds and maturity-matched Treasuries); and, (4) credit rating. Using data to calculate these measures for the 1,500 largest U.S. firms, along with associated monthly stock prices, over the period September 1991 (limited by availability of credit spread data) through December 2009, they find that:

  • Over the entire sample period, a hedge portfolio that is long (short) the equally weighted fifth of the stock sample with the highest (lowest) book-to-market ratios, reformed monthly, generates an annualized gross value premium of 7.0%.
  • For all four measures of distress risk, high book-to-market ratios are related to distress risk. However, growth stocks do not exhibit below-average levels of distress risk. Also, after correction for the size effect, the positive relationship between book-to-market ratio and distress risk disappears for all four measures.
  • Moreover, the relationship between distress risk and future returns is generally not positive, indicating that the value premium does not come from distress risk.
  • While value stocks outperform growth stocks during┬áboth economic expansions and contractions, high-risk stocks based on all four risk measures exhibit large underperformance during contractions.
  • Separately, while there is a negative relation between firm size and distress risk, there is no evidence that the size effect concentrates in high-risk firms.

In summary, evidence indicates that the value premium is distinct from the financial riskiness of firms as measured by four alternative measures of firm distress.

In other words, investors should be able to pursue the value premium without concentrating in risky firms.

Note that adding trading frictions to the above estimation of the value premium would reduce its magnitude, although trading frictions are relatively low during the sample period.

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