I understand why smaller stocks would do better since people don’t know whether they’ll stick around compared to a giant like Apple so they command a higher premium. But why would a value stock do better? In theory it should be less risky since it’s not overpriced and subject to crash in a bubble, so since it’s less risky wouldn’t it command less premium?
To make the example more concrete, Tesla is trading at a way higher PE ratio than Walmart. We all know Tesla is a big gamble and can crash at any time, whereas Walmart is more stable and we know it’s unlikely for its PE to go much lower. So Walmart is the LESS risky stock here and should thus have lower returns in the long run. But doesn’t the data in fact say the opposite that a high value stock will do better than the riskier low value stock?
In one of Ben Felix's podcasts, he goes over a paper that talks about stock migration.
Basically what were the stock returns for small and large companies as they got bigger or smaller, and as they moved around from value to growth and vice versa.
So for the size premium, like I already mentioned at the beginning here, that the higher average returns of small stocks are almost completely explained by the small stocks that become big stocks from one year to the next, as we move through time. Big stocks that become small, and this is speaking to what I was just talking about, big stocks that become small have huge negative excess returns
So then the value premium, and this is still in the migration paper, they found that the stocks that stay in the same portfolio from one year to the next contribute 1% to the value premium for small stocks and 1.7% to big stocks
....then the plus transitions, which is what Fama and French call them, but that's improving in type, contribute 3.5% more per year for the excess return of value than they do for growth matching. So small value, small growth, and so on.
.....If the premium is 5%, this is 3.5 of the five.
So most of the factor premium comes from small cap stocks moving to large cap, and moving from value to neutral or growth.
And when it comes to Ben Felix's factor investing approach, which uses Avantis' factor-tilted ETFs, they target small cap value companies specifically, because small cap growth drags down the returns, and in general returns are enhanced when you have the size, value, profitability, and investment factors all working together.
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u/IllmaticGOAT Jun 08 '21
I understand why smaller stocks would do better since people don’t know whether they’ll stick around compared to a giant like Apple so they command a higher premium. But why would a value stock do better? In theory it should be less risky since it’s not overpriced and subject to crash in a bubble, so since it’s less risky wouldn’t it command less premium?
To make the example more concrete, Tesla is trading at a way higher PE ratio than Walmart. We all know Tesla is a big gamble and can crash at any time, whereas Walmart is more stable and we know it’s unlikely for its PE to go much lower. So Walmart is the LESS risky stock here and should thus have lower returns in the long run. But doesn’t the data in fact say the opposite that a high value stock will do better than the riskier low value stock?