Stock Premiums Research Articles

On Value Premium, Part II: The Explanations

Much academic work has been done to prove that value premium exists. The center of debate however, lies on the reason for its existence. This paper will be a survey on different explanations to the existence of value premium which includes risk premium for value stocks, judgmental bias and agency costs, data mining, survivorship bias and company size’s premium. Among all, judgmental bias and agency costs comes out to be the one suffered from least counter-arguments.

Taking Stock or Cashing In? Shareholder Style Preferences, Premiums and the Method of Payment

We develop and test hypotheses on the impact of target shareholders’ investment style preferences on the method of payment and premiums in acquisitions. Stock offers (unlike cash offers) allow target shareholders to defer capital gains taxes. This deferral value, however, depends on target shareholders’ willingness to retain acquirer stock. The empirical findings support our hypotheses. Bid premiums in stock offers are negatively and jointly related to target shareholder tax liabilities and to variables proxying for target shareholder willingness to hold acquirer stock. Moreover, the difference between predicted cash and stock premiums due to these factors signi cantly explains the method of payment choice.

IFRS fair value elections signal stock premiums and lower interest

This research emphasizes whether UK companies choose cost or fair value for property, plant, and equipment under International Accounting Standard 16. For equity, stock price premiums result from making this election and obtaining status as the high-quality financial reporter. For debt, this status leads to lower interest rates. The former is tested through price to earnings ratios whereas the latter involves review of interest rates.

Forecasting the Size Premium Over Different Horizons

In this paper, we provide evidence that the small stock premium is predictable both in-sample and out-of-sample through the use of a set of lagged macroeconomic variables. We find that it is possible to forecast the size premium over time horizons that range from one month to one year. We demonstrate that the predictability of the size premium allows a portfolio manager to generate an economically and statistically significant active alpha.

Management Insights

Management Insights

The value premium and the January effect

PurposeThe purpose of this paper is to investigate the seasonal effect in the value premium puzzle. It studies whether the book‐to‐market effect is an outcome of the January effect observed among stock returns.Design/methodology/approachThe paper uses returns of portfolios based on size and BE/ME ratios as Fama and French suggest to define value premium and investigate the seasonality of the BE/ME effect. The paper tests whether the value premiums observed among large and small stocks are different in January and non‐January months. It examines the turn‐of‐the‐year effect on the value premium by analyzing the returns of BE/ME portfolios during the first and last ten trading days of a calendar year.FindingsEmpirical evidence supports the fact that value premium has different patterns in January and non‐January months for large and small capitalization firms. It was found that large stocks have a significant value premium only in January and this high January value premium among large stocks is mainly driven by loser stocks at the turn of the year. In contrast with large stocks, the value premium of small stocks occurs only in non‐January months.Originality/valueThis paper shows that value premium of large and small stocks are different in January and non‐January months. Furthermore, the past performance of stocks plays a key role in the observed January value premium among large stocks. Finally, this study provides evidence to show that the value premium among large stocks may be explained by investor trading behavior.

Shareholder Value In The Third Wave Of Acquisitions

Acquisition activity in the United States has occurred in three distinct waves. During the 1960s, acquisitions were predominantly made in areas unrelated to the acquiring firms. Later analysis of this conglomerate boom generally indicated that little or no shareholder value was created in this process. A second wave of acquisition and divestiture activity in the 1980s was characterized by the unwinding of the conglomerates and a search for synergy between the buyer and the acquired firm. The evidence on value creation for this period is somewhat more encouraging, although most studies indicate that firms did not succeed in creating profits through acquisitions. A third wave of acquisitions occurred in the late 1990s. This was an unprecedented era of merger and acquisition activity. Nearly $4 trillion worth of mergers occurred from 1998-2000. This represents a volume of activity greater than the previous 30 years put together. This study examines the returns to acquiring firms during this period and compares them to previous studies of acquisition performance. Was it different this time? This study indicates that shareholder value was generally reduced in making acquisitions, although some factors can mitigate the degree of poor performance. On average, acquiring firms lost 4-7% from making acquisitions. There is evidence to support the conventional wisdom that firms often overpay making acquisitions and that the size of the stock premium can be tied to firm performance. However, after controlling for the price premium, there is significant evidence of wealth creation (synergy) from the transaction.

Liquidity Premium and Consumption

We study the risk exposure of liquidity portfolios to labor income and consumption risk in the long run using a dynamic general equilibrium model that features flexible labor-leisure choice and recursive utility. We find that investors are willing to pay price premium for liquid stocks because these stocks provide a good hedge against labor income risk and long-run risk. With moderate risk aversion, the model-implied long-run liquidity premium matches the observed liquidity premium of 5.67% per annum, with about 70% attributed to compensation for labor income risk and 30% to consumption risk in the long run.

Loss Aversion with a State-Dependent Reference Point

This study investigates reference-dependent choice with a stochastic, state-dependent reference point. The optimal reference-dependent solution equals the optimal consumption solution (no loss aversion) if the reference point is selected fully endogenously. Given that loss aversion is widespread, we conclude that the reference point generally includes an important exogenously fixed component. We develop a choice model in which adjustment costs can cause stickiness relative to an initial, exogenous reference point. Using historical US investment benchmark data, we show that this model is consistent with diversification across bonds and stocks for a wide range of evaluation horizons, despite the historically high risk premium of stocks compared to bonds.

Time-variation in the value premium and the CAPM: evidence from European markets

Many previous studies document a robust premium for value versus growth stocks in international markets. We show that this premium is driven by few years where High Minus Low (HML) returns are high and significant. For instance, for 12 European markets the HML return is statistically significant, on average, approximately 36% of the years and for these statistically significant years the average monthly HML return is 2.24%. For the rest of the years (i.e. about 64% of the time) the average HML monthly return is only 0.54%. We also find that historical βs for value and growth portfolios vary significantly over time, change between good and bad economic conditions, and that value portfolio βs are not always smaller than growth portfolio βs for the majority of the sample markets. Finally, when time-variation in systematic risk is addressed, we cannot reject the zero-intercept hypothesis, i.e. portfolio returns appear consistent with the Capital Asset Pricing Model (CAPM).

Keynes Meets Markowitz: The Tradeoff Between Familiarity and Diversification

We develop a model of portfolio choice to nest the views of Keynes---who advocates concentration in a few familiar assets---and Markowitz---who advocates diversification across assets. We rely on the concepts of ambiguity and ambiguity aversion to formalize the idea of investor's ``familiarity towards assets. The model shows that when investors are equally ambiguous about all assets, then the optimal portfolio corresponds to Markowitz's fully-diversified portfolio. In contrast, when investors exhibit different degrees of familiarity across assets, the optimal portfolio depends on (i)~the relative degree of ambiguity across assets and (ii)~the standard deviation of the estimate of expected return on each asset. If the standard deviation is low and the difference between the ambiguity about the familiar and unfamiliar assets is small, then the optimal portfolio is composed of a mix of both familiar and unfamiliar assets; moreover, an increase in correlation between assets causes investors to increase concentration in the assets with which they are familiar (flight to familiarity). Alternatively, if the standard deviation of the expected-return estimate is high and the difference between the ambiguity of familiar and unfamiliar assets is large, the optimal portfolio contains only the familiar asset(s) as Keynes would have advocated. In the extreme case in which the ambiguity about all assets and the standard deviation of the estimated mean are high, then no risky asset is held (non-participation). The model also has empirically testable implications for trading behavior: in response to a change in idiosyncratic risk the Keynesian portfolio always exhibits more trading than the Markowitz portfolio, while the opposite is true for a change in systematic volatility. In the equilibrium version of the model with heterogeneous agents who are familiar with different assets, we find that the risk premium of stocks depends on both systematic and idiosyncratic volatility, and that the equity risk premium is significantly higher than in the standard model without ambiguity.

Getting It All—for Less: An In-Depth Study of Remaining Stake Acquisitions

Abstract In a previous analysis of remaining stake acquisitions (see “Wanting It All: Issues When You Already Have Control,” Business Valuation Review, July 2007, p. 38), the authors analyzed 67 remaining stake acquisitions; those acquisitions indicated a range of stock premiums of 30% to 45%. To build upon that work, the authors expand their scope and evaluate a larger sample of 257 transactions in order to retest the previously indicated premium range. In addition, they analyze relative returns (the premium or discount of the remaining stake acquisition relative to its peer acquisitions) and hypothesize on and test the key drivers of those relative returns.

Keynes Meets Markowitz: The Tradeoff between Familiarity and Diversification

We develop a model of portfolio choice to nest the views of Keynes - who advocates concentration in a few familiar assets - and Markowitz - who advocates diversification across assets. We rely on the concepts of ambiguity and ambiguity aversion to formalize the idea of an investor’s toward assets. The model shows that when an investor is equally ambiguous about all assets, then the optimal portfolio corresponds to Markowitz’s fully diversified portfolio. In contrast, when an investor exhibits different degrees of familiarity across assets, the optimal portfolio depends on (i) the relative degree of ambiguity across assets, and (ii) the standard deviation of the estimate of expected return on each asset. If the standard deviation of the expected return estimate and the difference between the ambiguity about familiar and unfamiliar assets are low, then the optimal portfolio is composed of a mix of both familiar and unfamiliar assets; moreover, an increase in correlation between assets causes an investor to increase concentration in the assets with which they are familiar (flight to familiarity). Alternatively, if the standard deviation of the expected return estimate and the difference between the ambiguity of familiar and unfamiliar assets are high, then the optimal portfolio contains only the familiar asset(s) as Keynes would have advocated. In the extreme case in which the ambiguity about all assets and the standard deviation of the estimated mean are high, then no risky asset is held (non-participation). The model also has empirically testable implications for trading behavior: in response to a change in idiosyncratic volatility, the Keynesian portfolio always exhibits more trading than the Markowitz portfolio, while the opposite is true for a change in systematic volatility. In the equilibrium version of the model with heterogeneous investors who are familiar with different assets, we find that the risk premium of stocks depends on both systematic and idiosyncratic volatility, and that the equity risk premium is significantly higher than in the standard model without ambiguity.

Selection of an Optimal Index Rule for an Index Fund

Several empirical studies document a substantial price premium for stocks in the S&P 500 index. For index investors this creates a recurring cost: as the index is updated, they need to buy stocks with the premium and sell stocks without the premium. Different index rules can produce different index premia due to the different frequency and criteria of updating. We build a model to investigate the behavior of the index turnover cost and the portfolio performance of a mechanical index fund under a market-cap rule, an exogenous random rule, and a deterministic rule. We find that the rational anticipation of future index composition reflected in prices today eliminates any first-order differences in index fund performance across the three index rules. As the index investors become a large part of the market, the non-index investors become less diversified, and this induces hedging motives which hurt the index investors especially under a market-cap rule. JEL classification: G12, G14

Loss Aversion with a State-Dependent Reference Point

This study investigates reference-dependent choice with a stochastic, state-dependent reference point. The optimal reference-dependent solution equals the optimal consumption solution (no loss aversion) if the reference point is selected fully endogenously. Given that loss aversion is widespread, we conclude that the reference point generally includes an important exogenously fixed component. We develop a choice model in which adjustment costs can cause stickiness relative to an initial, exogenous reference point. Using historical U.S. investment benchmark data, we show that this model is consistent with diversification across bonds and stocks for a wide range of evaluation horizons, despite the historically high-risk premium of stocks compared to bonds. This paper was accepted by Peter Wakker, decision analysis.

Regime Switching and Stock-Bond Co-Skewness

If asset returns have systematic skewness, expected returns should include rewards for accepting this risk. This idea can be extended to two different asset classes: stocks and bonds. There are two systematic skewness measures: stock co-skewness (the relation between stock return and bond volatility) and bond co-skewness (the relation between bond return and stock volatility). With monthly data from the past 150 years for both the U.S. and U.K. markets, we characterize conditional co-skewness between stock and bond premiums using a bivariate regime-switching model. Both U.S. stock and bond co-skewnesses command negative ex ante risk premiums. If these measures increase by their one standard deviation, the expected stock and bond premiums will decrease by 4.5 percent and 0.6 percent per year respectively. The cross-market co-skewness effects are also present in U.K. data.

Time-Variation in the Value Premium and the CAPM: Evidence from European Markets

Many previous studies document a robust premium for value vs. growth stocks in international markets. We show that this premium is driven by few years where HML returns are high and significant. For instance, for twelve European markets the HML return is statistically significant, on average, approximately 36% of the years and for these statistically significant years the average monthly HML return is 2.24%. For the rest of the years (i.e. about 64% of the time) the average HML monthly return is only 0.54%. We also find that historical betas for value and growth portfolios vary significantly over time, change between good and bad economic conditions, and that value portfolio betas are not always smaller than growth portfolio betas for the majority of the sample markets. Finally, when time-variation in systematic risk is addressed we cannot reject the zero-intercept hypothesis; i.e portfolio returns appear consistent with the CAPM.

Optimal Portfolio Balancing Under Conventional Preferences and Transaction Costs Explains the Equity Premium Puzzle

Following Constantinides' (1986) seminal approach and introducing transaction costs in the Pagano (1989) model, conventional CARA investors with heterogeneous endowments trade to construct optimal portfolios. We calibrate to the 1896-1994 equity and bond markets to show that gains from trade are high and, thus, investors require a high illiquidity premium even for a modest transactional charge. Excluding risk premia, exchange of equity and bonds by N strategic investors, as , under a mere 1% round-trip transaction cost induces a 6% illiquidity (equity) premium. Unlike existing literature, our findings are consistent with most stylized empirical facts. We recover the elasticity of trading demand from the excess equity return to confirm a major implication of the model. Among many other, so called, anomalies, we appear to explain the apparent irrational exuberance of equity markets, the 600% price premium for otherwise identical A stock over B stock in China, the low risk-free rate, the 20% letter stock premium and the lower return on the run bonds. Because illiquidity premia do not necessarily imply consumption volatility, variance bounds tests become irrelevant.

Index Fundamentalism Revisited—Redux

The findings in ?Index Fundamentalism Revisited? on the relative performance of Vanguard synthetic active and index portfolios are explained largely by differing exposures to the value and small–stock premiums. Other findings such as the relative 15–year annualized returns and relative 2000–2002 performance of the two portfolios are similarly explained. Left unexplained is the synthetic active portfolio9s lower volatility relative to the synthetic index portfolio.

Value versus growth stocks in Singapore

This study examines value and growth stocks in Singapore. Specifically, we examine the value premium up to 5 years after the value and growth portfolio formation. We also examine if growth (value) stocks really indicate higher (lower) company profits in the later years, whether analysts’ forecasts are overly optimistic/pessimistic, and if earnings and earnings growth exhibit mean reversion. Our findings are, first, there is a value premium for Singapore stocks, but the premium is concentrated in the first 2 years after the portfolio formation. Second, value (growth) stocks do indicate low (high) earnings growth rates and low (high) return on equity (ROE) in the following years. Third, earnings growth is significantly overestimated for growth stocks but it is not underestimated for value stocks, indicating a one-way over-reaction. Finally, there is some evidence of mean reversion for excess ROE but not for excess earnings growth rates.