Value Stocks: When the Price Isn’t Right
Earnings quality and the value premium
BY George Athanassakos | August 31, 2016
Ever since the 1970s, when it was discovered that value stocks (i.e., high E/P stocks) tend to have higher average returns than growth stocks (i.e., low E/P stocks), there has been a large body of academic research which has confirmed the existence of a value premium, namely, that value stocks outperform growth stocks.
Academic research has subsequently sought to explain the superior performance of value stocks. Two explanations have emerged along these lines of inquiry: a risk-based and a mispricing/behavioral-based view of the drivers of the value premium. Proponents of the efficient market hypothesis argue that value investing produces superior performance because value portfolios are fundamentally riskier than growth portfolios and once risk is taken into account the “anomaly” will dissolve, i.e. superior performance should be explained away.
Alternative explanations of the value premium are based on mispricing/behavioral biases. Investors, for behavioral or institutional reasons, commit systematic errors when they value securities that induce them to pay too much for winners (low E/P or B/P stocks) and too little for losers (boring, poorly performing, unknown and out-of-favor (high E/P or B/P) companies). These biases shape investment returns and the value premium. In fact, the discussion referred to above as evidence supporting a possible risk explanation may also be consistent with a behavioral explanation as such stocks, e.g. distressed firms or firms facing litigation or declines in performance, become undesirable to own and hence likely mispriced.
The jury is still out regarding the drivers of the value premium as the evidence is mixed. Some researchers find support for the risk-based explanation of the value premium while others find no support for it.
As a result, there is reason to believe that it could be both risk and behavioral factors that drive the value premium since what value investors do may actually involve both risk and mispricing. While asset pricing theory favors risk as an explanation of the value premium because financial markets are not natural phenomena but manmade, human factors, and so behavioral explanations, must play a role in the pricing of securities. As a result, both risk and behavioral factors may be behind the value premium.
Most of the work relating risk and the value premium has focused on systematic risk, namely, beta. But beta risk is unlikely to drive the value premium. Evidence shows that the CAPM beta of value stocks is well below the CAPM beta of growth stocks. While papers providing evidence against the risk-based explanation seem to test the effect of systematic risk on the value premium, others that focus on standard deviation of returns or analysts’ forecasts (a proxy for total risk) seem to find better support for a risk-based explanation. This begs the following question: What if the value premium is affected by unsystematic rather than systematic risk? And indeed research shows that idiosyncratic risk captures the value premium and that the value premium is compensation for exposure to time varying risk.
Despite this, no paper has investigated the sources of the idiosyncratic risk as they relate to the value premium. Evidence suggests idiosyncratic risk is associated with deteriorating earnings quality, based on the theory that the latter causes noisier earnings. The association between idiosyncratic volatility and worsening earnings quality is more pronounced when the deterioration in earnings quality is related to managerial discretion. However, to date, the risk-inducing effect of earnings quality has been examined independently of the value – growth phenomenon. Evidence suggests that growth stocks are associated with high accruals, i.e. poor earnings quality, but what about value firms? Among value stocks there are several firms facing bankruptcy or suffering from financial distress, overcapacity, decline in profitability or threat of legislative or regulatory punishment. All these circumstances provide incentives to manage earnings. The resulting fall in earnings quality may contribute to a rise in idiosyncratic risk and therefore to the value premium. As such, deteriorating earnings quality as a source of idiosyncratic risk could drive the value premium.
At the same time, earnings quality has been associated with mispricing through the accruals anomaly literature. Such research focuses on the fact that highly positive accruals tend to be overpriced by the market leading to lower abnormal returns in the subsequent period, when the market corrects. The accruals anomaly and the mispricing of growth stock may be related phenomena as firms with high sales growth (growth stock) are likely to have larger positive accruals than firms with low sales growth (value firms). Therefore, the mispricing of growth stocks may be due to the mispricing of growth stocks’ poor earnings quality (positive accruals) and may explain the underperformance of growth stocks in subsequent periods, when the market corrects. This provides support to the argument that the value premium may be driven by the mispricing of the poorer earnings quality of growth stocks. In other words, based on the above arguments we hypothesize that earnings quality may underlie both a risk and a mispricing explanation for the value premium.
The purpose of this paper, a joint work with Vasiliki Athanasakou, is to examine whether a value premium exists over our sample period, whether systematic risk is driving the value premium, whether idiosyncratic risk does a better job than systematic risk in explaining the value premium, and more importantly whether earnings quality contributes to a risk, mispricing or both explanations for the value premium. We use a generic measure of earnings quality, i.e. earnings variability, and consider several alternative measures (e.g. accruals quality, abnormal accruals) in additional analysis.
Our initial tests affirm prior evidence that a value premium exists and depending on what measures one uses one can find support for both risk and mispricing based explanations of the value premium. While this may make some sense as was discussed earlier, it does not provide much comfort in terms of shedding light on the rationale for the value premium. Our research approach helps in this respect.
The role of mispricing
When we look at value and growth stocks across different earnings quality quartiles, a number of interesting results emerge. First, we observe that while a value premium is evident in the total sample, the value premium is actually driven by firms in poorer earnings quality quartiles. For example, the mean value premium for the best earnings quality firms is 0.006 (but not statistically significant), whereas the corresponding value premium for the poorest earnings quality firms is 0.096 (t-test: 5.96). Second, mean one year returns are decreasing while moving from higher to lower earnings quality for growth stocks and increasing while moving from higher to lower earnings quality for value stocks. More importantly, the value premium increases as we go to lower earnings quality firms, and this is primarily because of a decline in one year ahead mean returns of the growth stocks across the earnings quality quartiles and a corresponding rise in mean returns of the value stocks. The return differential between highest and poorest earnings quality is -0.027 for growth stocks (t-test = -2.39) and 0.064 for value stocks (t-test = 4.10); one year ahead mean returns of growth stocks decline from 0.128 for the best earnings quality firms to 0.101 for the poorest earnings quality firms, whereas for value stocks one year ahead mean returns actually rise from 0.134 for the best earnings quality firms to 0.197 for the poorest earnings quality firms. This is an important result and sheds light on the drivers of the relationship between earnings quality and the value premium. Had we only had access to the value premium across different earnings quality quartiles, it would have been difficult to conclude whether the driver of this relationship is risk or mispricing. But in addition to the value premium, the ability to observe one year ahead returns for both value and growth stocks across the different earnings quartiles enables us conclude in favor of the mispricing hypothesis for growth stocks and the risk hypothesis for value stocks.
Deteriorating earnings quality that increases the value premium mainly through the mispricing of growth stocks, is consistent with the mispricing hypothesis, while deteriorating earnings quality that increases the value premium mainly through the riskiness of value stock is consistent with the risk hypothesis. Two results support this conclusion. First, in general, glamour stocks tend to be bid up by investors. But the less visible are bid up the most. As a result, the poor quality growth stocks being less visible than the higher quality growth stocks are bid up more leading to the lower returns going forward observed for poor quality growth stocks. This evidence favors the mispricing (overvaluation) for growth stocks. Second, deteriorating earnings quality is associated with a sharp rise in analyst uncertainty (and idiosyncratic risk) for value stocks and a rise in forward returns going from good to poor earnings quality value stocks. This evidence favors a risk-based explanation for value stocks. These results taken together suggest that earnings quality issues might be underlying both the mispricing and risk based explanations for the value premium and that combining earnings quality measures with the value and growth stock returns helps reconcile the conflicting evidence on the rationale for the value premium. Deteriorating earnings quality contributes to the mispricing (overpricing) of growth stocks and to analyst uncertainty (risk) of value stocks.
The study yields insights that could be used to enhance investment strategies on value stocks with expected returns that outperform previous predictive variables. Value investors screen to single out value stocks that appear to be undervalued and then value them to identify stocks that are truly undervalued stocks – a very time consuming process. By unraveling the effect of reported earnings quality on the value premium, our study suggests a way of further screening value stocks to improve value investing strategies. At the same time, our results offer an explanation not only for the drivers of the value anomaly, but also for the sources of the drivers of this anomaly.