Week 20 Day 2: Value Stocks: Buying What Others Dislike

Value stocks are companies with low price-to-earnings ratios, high dividend yields, and stock prices that seem cheap relative to their assets or earnings. Think banks, energy companies, utilities, and mature industrials. They are not exciting. That is the point. The market overprices excitement and underprices boring.

Value investing was pioneered by Benjamin Graham and David Dodd in their 1934 book 'Security Analysis,' and refined by Warren Buffett ('It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price'). The value premium: from 1926-2023, value stocks (lowest 30% price-to-book) outperformed growth stocks (highest 30% price-to-book) by approximately 3% annually (Fama-French data). But the premium is not consistent -- value had a historically bad decade from 2010-2020, underperforming growth by approximately 5% annually. This led many to declare 'value is dead.' Then in 2021-2022, value outperformed growth by over 20%. The value premium does not work every year, but over rolling 15-20 year periods, it has been positive in nearly every window. Implementation: VTV (Vanguard Value ETF, 0.04%), SCHV (Schwab Value, 0.04%), IUSV (iShares Value, 0.04%). A simple value tilt: instead of 100% VTI, allocate 70% VTI + 30% VTV. This increases your value exposure without abandoning broad diversification.

Why the value premium exists is one of the most debated questions in finance. The risk-based explanation (Fama and French, 1993, 1996): value stocks are riskier because they tend to be companies in financial distress, with high leverage, cyclical earnings, and operating inflexibility. The higher return compensates for this risk. The behavioral explanation (Lakonishok, Shleifer, and Vishny, 1994): investors systematically overreact to poor past performance, driving value stocks below fair value. DeBondt and Thaler (1985) showed that past losers outperform past winners over 3-5 year horizons, consistent with overreaction. A third explanation: the investment CAPM (Zhang, 2005) argues that value firms have high cost of reversing capital in place, making their cash flows riskier in recessions -- hence a risk premium. The 2010-2020 value underperformance challenged all explanations. Arnott, Harvey, Kalesnik, and Linnainmaa (2021) argued that much of the underperformance was driven by valuation spread widening (growth stocks becoming more expensive relative to value stocks), which is mean-reverting. When the spread is wide (as it was in 2020, reaching levels exceeded only in the dot-com bubble), subsequent value outperformance has historically been strong. This framework correctly predicted value's 2021-2022 resurgence.