Comparative Performance and Risk of Value Investment Strategies

The value premium is a widely documented anomaly that has two primary but conflicting explanations; higher fundamental risk and irrational investor behavior. This study examines the premium by calculating the performance of various value investing strategies for the periods of 2001 to 2011 as well as 1991 to 2011. It is observed that value portfolios sorted on the price-to-earnings (P/E) and price-to-cash flow (P/CF) ratios produce statistically significant premiums, with a geometric average return premium of nearly 20 percent for value over growth. Further, contrary to prior research, for both periods examined the book-to-market (B/M) ratio does not successfully sort outperforming value stocks. Instead both B/M value and growth portfolios deliver high returns in excess of the market. Size also proves to be a significant determinant of return, where excess returns are implied for small capitalization firms. When the riskiness of value versus growth is examined, value does not prove to be riskier than growth by traditional risk measures. This, along with strong reversion of P/E and P/CF value stocks in the year post portfolio formation, suggests a behavioral interpretation for the premium where investor overreaction and limits to cognitive information processing add to deviations from underlying value.