What Drives the Value Premium? Surprising News...

Students of financial markets broadly agree on the existence of a value premium: cheap stocks do better over time than expensive stocks.

But there is broad disagreement about why and how the value premium works. An interesting new paper out of UC San Diego provides new empirical support for our preferred explanation — that forecasting errors drive the majority of the value premium.

The study found that 80% of excess returns to value investing come on days when news is released. Value returns are 7x higher on earnings announcement days and 2x higher on days where Dow Jones publishes news about a given company.

Figure 1: Anomaly Returns around Earnings Announcement Days

Source: Engelberg et al., “Anomalies and News.”

Investors are too optimistic about expensive stocks and too pessimistic about value stocks. When news comes out, it has a disproportionately positive impact on value stocks and similarly negative impact on glamour stocks. The reality of the future clashes with the biased expectations of investors, which drives the value premium.

Analyst earnings estimates appear to support this story, with value stocks consistently beating earnings and glamour stocks consistently missing them.

This research is consistent with our worldview: the best way to make money in markets is to bet against the hubris of other participants. Assume that the future will unfold unpredictably and profit from the systematic mispricing of others who are overly confident in their predictions.

If investors focus on the knowable important things, the unpredictable important things will take care of themselves.

Figure 2: Importance vs. Predictability