0
$\begingroup$

I'm currently working on potential explanations behind the value premium. As there're two school of thoughts, rational pricing describing fundamental risk in value stocks vs. irrational behavior, I stumbled across a potential risk-based explanation in form of costly reversibility (of investments) and countercyclical cost of risk which I don't fully understand. One source about that topic would be Zhang, 2005, The Value Premium, Journal of Finance.

I understand that expanding capital is cheaper than cutting capital as you tipically have costs in cutting in form of selling below your inital investment. Value firms derive more of their returns from assets-in-place and are therefore more riskier as it's harder for them to cut capital and they're stuck with more unproductive capital (which their returns are highly dependent of). Vice-versa, in economic upturns they don't need to invest as much as growth companies as they first use their previously unproductive capital before expanding.

Additionally, the cost of risk is countercyclical as investors demand higher a higher risk premium in bad times in order to have an incentive to hold (risky) stocks instead of cash.

Yet I don't fully understand what they mean with the following: "As expanding capital is relatively easy, the dividends and returns of growth firms do not covary much with economic booms. The net effect is a high dispersion of risk between value and growth strategies in bad times and a low or even negative dispersion of risk in good times."

Isn't it the case that risk is higher for value stocks in bad times and higher for growth stocks in good times?

The only way I could see that a premium is justified is in a way that the price of risk is higher in bad times, and therefore value companies have to pay higher returns as they're riskier in that times. In good times growth companies have to pay a higher price of risk than value companies but the price of risk in generally lower, so the overall return is higher for value companies. Yet it's not really written anywhere. Am I missing something or is my interpretation right?

Thanks for any help!

$\endgroup$

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Browse other questions tagged or ask your own question.