It has been well-documented that value stocks have provided higher expected returns than growth stocks. However, there is a great debate about the source of that premium: Is it risk-based or is it related to behavioral errors that create persistent mispricings? There are many papers presenting arguments on both sides. Hence the debate.

Cathy Xuying Cao, Chongyang Chen and Vinay Datar contribute to the literature with their study, “Value Effect and Macroeconomic Risk,” which appears in the Fall 2017 issue of the Journal of Investing. They examined to what extent the value effect reflects macroeconomic risk — in other words, how the returns from value and growth strategies are sensitive to the change in macroeconomic conditions.

They used intuitive proxies for macroeconomic conditions: the growth rate of industrial production, the term premium, the default premium, and the changes in expected and unexpected inflation. If the value premium is driven by risk, value stocks should have more exposure to these metrics. To capture the value effect, they used two proxies: the book-to-market (B/M) equity ratio and earnings-to-price (E/P) ratio. Their data sample covers the period from July 1963 through June 2012.

The following is a summary of their findings:

  • Value stocks have higher sensitivities than growth stocks to certain macroeconomic factors, specifically the growth rate of industrial production, the term spread, the default premium and unexpected inflation. The risk loadings of both high-B/M and low-P/E firms are substantially larger (and statistically significant) than the loadings of low-B/M firms with respect to each of the macroeconomic factors.
  • The value premium changes with economic conditions and value strategies tend to underperform growth strategies during NBER-defined recession periods. For example, during the 2008 crisis, the cumulative investment return from a B/M value strategy was -58.8 percent while the return was -49.8 percent for a growth strategy.
  • The average estimated R-squared value is at least 60 percent, suggesting that the factors can explain a large proportion of the variation in the average returns of the portfolios. The positive risk premiums for industrial production and default risk indicate that typical investors want to insure against real systematic production shocks and against the unanticipated increase in default uncertainty.

    • Cao, Chen, and Datar concluded:

    The evidence suggests that macroeconomic risk plays a central role in driving the positive value-return relation…. Our evidence supports the risk-based explanation for the value premium.

    Importantly, they add:

    Value investment is often perceived to be safer than growth investment. Our results suggest differently: Value investment has greater risk exposure to macroeconomic risk than growth investment. The higher return that value investors achieve is at the cost of bearing higher exposure to unanticipated macroeconomic shocks.

    Is the Value Premium Really Driven By Macro Risk?

    As previously mentioned, there are many other papers providing support for the risk-based explanation of the value premium. In our book, “Your Complete Guide to Factor-Based Investing,” Andrew Berkin and I reviewed some of the literature providing this support. The following is taken from our book.

    Supporting Evidence

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