Value stocks: The risk story

[tms]

I had a challenge on the risk based story behind value stocks. He said: "Aren't you theoretically better protected by the downside of asset coverage in low p/bv or (high book-to-market) company?".

I've struggled with this point as well.

[Ever Ready]

Bear Stearns, Lehman Bros., GM, Etc.
Book value can evaporate, just like dividends or growing earnings.

[Call_Me_Op]

I had a challenge on the risk based story behind value stocks. He said: "Aren't you theoretically better protected by the downside of asset coverage in low p/bv or (high book-to-market) company?".

I've struggled with this point as well.

Depends upon one's viewpoint. Most people buy stocks in hopes of making a lot of money, not to get 50 cents on the dollar from asset sales in a bankruptcy.

[docneil88]

I had a challenge on the risk based story behind value stocks. He said: "Aren't you theoretically better protected by the downside of asset coverage in low p/bv or (high book-to-market) company?".

I've struggled with this point as well.

Hi tms, I think that's a good argument.

Another argument is this: The market is not perfectly efficient. Stock prices tend to overshoot their fair value on both the upside and the downside. Value screens catch significantly more of those that have overshot on the downside than growth screens do, thus reducing risk. And value screens tend to catch less of those that have overshot on the upside than growth screens do, thus reducing risk.

On the other hand, value stocks tend to be more leveraged than growth stocks, which increases risk. (Does anyone have some stats that quantify this difference in leverage?) But one can easily adjust for the increased leverage within value stocks by deceasing one's equity percentage somewhat. (And if a highly leveraged value company you own directly or indirectly goes bankrupt, you can take a bit of consolation in an increased bond fund allocation and in the fact that the bondholders of the company will be sharing your pain and the losses associated with the bankruptcy in a big way. ) Best, Neil

[docneil88]

Standard deviation is one indicator of risk level. Over long periods of time, the standard deviation of value stocks as a group has been about the same as for growth stocks. But if an adjustment were made for the higher leverage of value stocks, I believe the standard deviation for them would be significantly less than for growth stocks.

Here is an interesting paper that supports the idea that the higher leverage of value stocks increases their risk, and that in turn explains the long-term outperformance of value over growth (i.e. the "value premium"):
"Can Operating Leverage be the Cause of the Value Premium?" by Luis García-Feijóo and Randy D. Jorgensen http://papers.ssrn.com/sol3/papers.cfm? ... id=1077739 (free download with no registration required). IMO the added leverage in value stocks explains some but not all of the value premium. Best, Neil

[pkcrafter]

tms wrote:

Aren't you theoretically better protected by the downside of asset coverage in low p/bv or (high book-to-market) company?"

Not if the low price/book is due to distress and the company is on the edge of failure. There are a lot of good companies with lower than average price/book, but the value loading isn't much. When you get into highly distressed companies there is lots of loading and much higher risk.


Paul

[cato]

The problem with book value is that many of its components (bldgs, equipment, etc.) may be valued on acquisition price rather than current market price. In the current environment, that means book value may vastly overstate actual liquidation value.