The poor performance of value stocks versus growth stocks over the past decade has led to the belief that the value premium is dead. This, however, seems to be more a U.S. market phenomenon. The Canadian value premium persists, particularly for stocks with low prices. Before we proceed further, recall that:
- Value stocks are normally considered those that have low price-to-book ratios, growth stocks are those with high multiples of book value;
- The value premium refers to the positive difference between value and growth stock returns.
So why does the value premium endure in this country? A key factor is the industry structure. Canada does not have exponentially growing pharmaceutical and high-tech companies. This market is dominated instead by firms in the financial sector as well as by materials and energy stocks.
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The value premium is particularly strong in low priced Canadian stocks, according to my research with co-author Lucy Ackert of Kennesaw State University in Atlanta. From 1983 to 2018, these stocks realized an average value premium of 10 per cent compared with 2 per cent for the high priced variety. Low priced stocks tend to be more obscure, are followed by fewer analysts, and are typically less liquid than their high priced alternatives. Thus, these stocks tend to react more strongly to positive market sentiment, which is more prevalent than negative sentiment, leading to their higher value premium. This value premium has declined in recent years, but it continues to remain statistically positive in Canada for lower priced stocks, as opposed to the U.S. market, where the value premium has turned negative.
A more fundamental issue, though, is why there is a value premium in the first place. While it has been argued that the higher return to value is a premium for risk, my earlier research does not square with that view. Value stocks tend to have lower volatility compared with the market than growth stocks, they do better in recessions and recoveries, and they respond better to earnings surprises – on the upside and downside.
Could the value premium be the result of mispricing? If this were the case, it simply should not persist – particularly since everyone seems to be aware of it. The value phenomenon has received significant attention in practitioner circles as well as in the academic literature. However, recent evidence suggests that the United States is the only country with a reliable decline in the value premium after it became widely known.
Another potential factor driving the value premium is the strength of behavioural biases. Psychologists document people’s numerous systematic biases. One that is particularly unyielding is probability judgment error. Investors overweight extremely positive payoffs, leading them to overvalue assets with positively skewed outcomes. Growth stocks are akin to assets with a high probability of a large payout so investors subject to probability judgment error tend to pay too much for these stocks. On the other hand, investors who fall prey to this bias undervalue more stable value stocks, leading to a value premium.
Researchers Brent Ambrose, Yifan Chen and Timothy Simin of Pennsylvania State University provide another possible reason that can explain why there is still a value premium in Canada, but not in the U.S. They show that the value premium is larger in countries with high historical house-price appreciation compared with those that experience low house-price appreciation.
Their argument goes as follows: To support their growth, growing firms need to hire more labour. New workers demand more housing, and this puts an upward pressure on house prices. To attract new employees, firms need to reward them handsomely and compensate them particularly for high housing costs. Because of this, growing firms fail to return all proceeds from growth to their shareholders; part of those proceeds are paid out to employees as compensation for rising house prices that the increased demand for labour has caused.
The researchers find that, over the period 2000-2020, a long/short strategy that buys value stocks in a comparatively low house-price country (such as the U.S. or Greece) and shorts growth stocks in a high house-price country (such as Canada) would have produced a cumulative total return of 811 per cent compared with a 289-per-cent gain of the S&P 500. Put simply, the idea is to short a portfolio (not just one stock) of growth stocks in a high house-price market (where growth companies’ profits would be hurt by paying higher wages) and buy value stocks in a low house-price market. This way, growth stocks will be depressed in Canada compared with value stocks.
In a low house-price environment, the cash flows of high growth firms are not hurt as they do not have to pay high wages to compensate for high house prices, and so they tend to do better relative to value stocks.
The Canadian housing market has been on fire for the past 10 years, while the Greek and the U.S. markets have not – which, if this thesis is correct, would certainly explain why the value premium has not been dead in Canada.
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Ivey Business School, University of Western Ontario.
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George Athanassakos