Buying value stocks has been viewed as exceptionally risky by many investors and by some eminent finance professors.
But a new study has concluded that these stocks are not particularly risky, suggesting that as a class, they may simply represent good value for investors.
Value stocks are cheap, at least by one popular definition, which says that their prices are low relative to their book values.
Many investors have been more comfortable purchasing growth stocks, which trade at higher price-to-book-value ratios but have earnings that rise more quickly.
Why investors prefer these stocks has been a puzzle because value stocks have performed better over the long run.
Two finance professors, Eugene F. Fama of the University of Chicago and Kenneth R. French of Dartmouth, report that value stocks have beaten growth stocks by 3.7 percentage points a year on average from 1927 to the end of last year. Some researchers suspect that the difference may be smaller than this, but none argue that growth stocks have outperformed value stocks.
The professors subscribe to a theory that says financial markets over the long run are rational and efficient. They have argued that value stocks must be riskier than growth stocks because there would otherwise be no reason for markets to reward investors for buying them.
Disputing that theory has not been easy because it does not rely on independent evidence. Three researchers nevertheless think that they have found a novel way of refuting it.
Two of them are finance professors, Alon Brav of Duke and Roni Michaely at Cornell, and the third is an accounting professor, Reuven Lehavy from the University of Michigan. Their conclusions are presented in a working paper, "Expected Return and Asset Pricing," which is available online at papers.ssrn.com/sol3/papers.cfm?abstract-idEQUALS360680.
They have tried to infer stocks' risk directly from the returns investors expect to achieve when they invest in themBecause it is impossible to poll all investors, the professors focused on the expectations of research analysts. The professors found no evidence among analysts that value stocks were any riskier than were growth stocks. The professors studied a Thomson First Call database that contained more than 7,000 yearly price forecasts made by analysts at brokerage firms from 1997 through 2001.
The brokerage analysts predicted that the average growth stock would rise more than 20 percentage points a year faster than would the average value stock.
To those who believe that the markets are rational and efficient, this is evidence that growth stocks are riskier than value stocks. But this new research suggests that there is no need to avoid all value stocks out of fear that they must be riskier. They may just be bargains.
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