Bridge over ocean
1 April 2014 CFA Institute Journal Review

Rationalizing the Value Premium in Emerging Markets (Digest Summary)

  1. Marvin Powell, CFA

To better understand the observed value premium in emerging markets, the authors research the financial market performance of Brazil, Turkey, India, and China during a period of economic growth. They find that the value premium is explained by economic fundamentals rather than a risk factor that is common to all firms.

What’s Inside?

Growth stocks, which have more investment leeway compared with a value stock, are understandably riskier than value stocks, which derive their market values from currently owned assets rather than from growth options. Yet, counterintuitively, growth stocks generally earn lower returns than value stocks. The authors suggest that growth stocks tend to hoard cash, which delays the implementation of a growth strategy, particularly during economic downturns. Although this behavior certainly limits growth firms’ exposure to risk, it consequently has negative effects on both their market valuations and returns.

How Is This Research Useful to Practitioners?

The authors attempt to rationalize the source of the value premium. They suggest that growth firms inherently possess growth options, which entails capital outlay at the expense of increased business risk. But value firms use collateral to increase leverage to boost earnings, which consequently increases financial risk. The authors suggest that this phenomenon is what differentiates growth firms from value firms. Furthermore, the range of options available to growth firms provides a utility that is separate from monetary returns. This utility is attractive to investors and causes growth firms’ stock prices to appreciate, thereby lowering future returns as a result of the cash drag.

The authors provide empirical evidence that the value premium does, in fact, exist in emerging markets under favorable economic conditions. Further evidence suggests that value stocks and growth stocks are not characterized by different levels of distress. After studying the time-varying pattern of conditional beta, the authors find that growth portfolios are more sensitive to size but less sensitive to leverage. This finding that growth portfolios are sensitive to changes in total assets reaffirms that the risk and return structure of growth firms is determined by their investment pattern.

These conclusions are significant because they provide further information regarding the source of the value premium, particularly in the realm of emerging economies. Having a better understanding of risk and return characteristics applicable to growth and value investments may help market participants better understand the investment landscape.

How Did the Authors Conduct This Research?

The basis for the authors’ research is the work of Fama and French (Journal of Finance 1995) and Daniel and Titman (Journal of Finance 1997). They gather financial data from DataStream for Brazil, China, India, and Turkey for the period of 1999–2009. To confirm the existence of a value premium, the authors use the Fama–French methodology in the construction of six portfolios. These portfolios represent various combinations of market value of equity (ME) and book value/market value of equity (BE/ME). Stocks with ME higher than the median are classified as big; those with ME less than the median are classified as small. For BE/ME, the three breakpoints are bottom 30%, middle 40%, and top 30%. The authors then calculate the value-weighted monthly returns for the six portfolios from July of year t to June of year t + 1.

To try to discover the source of the value premium, the authors use two techniques. In the first stage, they use measures of bankruptcy risk, proposed by Altman in his book Corporate Financial Distress and Bankruptcy (1993), to investigate whether firms with a high likelihood of distress, measured by the Z-score, also have a high BE/ME or value premium. In the second stage, the authors use 36-month rolling regressions to estimate the Fama–French three-factor model to derive time-varying distress coefficients for 25 portfolios sorted on size and BE/ME.

Abstractor’s Viewpoint

Having a detailed understanding of value and growth characteristics is critical for many investment professionals. This research offers an interesting approach to uncovering the source of the value premium. Ultimately, I hope further research expands on these findings, both in terms of countries analyzed as well as time periods analyzed. Expanded research should help investment professionals better understand how the value premium behaves in numerous economic environments.

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