How Risky Are Value Stocks?
Challenging Value as a risk premium strategy
August 2020. Reading Time: 10 Minutes. Author: Nicolas Rabener.
SUMMARY
- The Value factor is often explained as representing a risk premium or a behavioral bias
- However, financial analysts regard cheap stocks as less risky than expensive ones
- Data shows that expensive stocks were riskier than cheap ones, which challenges the risk premium theory
INTRODUCTION
Which of the following two portfolios comprised of US stocks would you consider riskier?
- Portfolio A: Amazon, Autodesk, Qualcomm, Advanced Micro Devices, and Netflix
- Portfolio B: Prudential Financial, AIG, Molson Coors, HP, and Bank of New York
The first portfolio contains mainly technology stocks and might be considered more future-oriented, compared to the second portfolio that is heavy on financials and is somewhat representative of the old economy (sorry HP!).
Would you change your view on the riskiness of these two portfolios, if you knew that portfolio A has a median price-to-book multiple of 28.9x and price-to-earnings multiple of 123.0x, compared to 0.6x and 8.8x for portfolio B, respectively?
Joachim Klement, a London-based investment strategist, recently highlighted a research paper from Merkle and Sextroh that shows that financial analysts consider cheap stocks less risky than expensive ones, i.e. portfolio B over portfolio A. However, that poses a conflict with academic literature, where the excess returns from Value are frequently explained by the factor representing a risk premium. If Value stocks are less risky, how can it be a risk premium strategy?
