This results in the securities being overpriced, but due to the expense and limited supply of small-cap stocks investors are unwilling to trade against the overpriced stocks, allowing the anomaly to persist.
The value factor
The value factor relates to the tendency for relatively cheap assets (trading at a discount to their fundamentals) to outperform expensive ones.
Common measures used to identify a value firm are ratios such as price-to-earnings and book-to-price. For example, stocks with a market capitalisation (value of outstanding shares) close to their book value (value of assets) are typically considered value stocks.
However, there are a wide range of approaches to determining value, based on different combinations of earnings, sales, and cash flows.
The value factor has a long history in financial research, dating back to the 1930-40s, through the seminal work of Benjamin Graham, the 'father of value investing'. It has maintained prominence in no small part due to the success of Warren Buffett, a student and protégé of his.
Graham recommended for investors to buy stocks at a discount to their intrinsic value, arguing that pricey stocks with high valuations leave little room to the upside, while cheaper stocks offer greater upside and potential ability for gain.
A step forward was taken in 1977, when Sanjoy Basu published his paper "Investment Performance Of Common Stocks In Relation To Their Price-Earnings Ratios", which found that companies with low stock prices relative to their earnings consistently performed better than as suggested by Fama’s efficient market hypothesis.
This was followed up by Rolf Banz’s 1981 paper "The Relationship Between Return and Market Value of Common Stocks", which also found a similar outperformance for smaller sized companies – while these stocks demonstrated greater volatility than their larger-cap counterparts, their returns were correspondingly higher.
However, the seminal piece of research into the value factor was carried out by Fama and French in their 1992 paper. This conclusively found that firms with high book-to-price ratios outperformed those with lower book-to-price ratios.
There has been great debate as to the source of the value premium. There is a belief among many academics that the value premium is actually an anomaly and the result of persistent pricing errors made by investors.
Similar to other factors, the explanations are typically broken down into risk-based explanations and behavioural-based explanations.
Risk-based explanations for the value factor include the concept that value stocks are cheap because they tend to be highly leveraged (high debt), face substantial earnings risk, and may be in distress. They therefore provide the potential for greater returns due to their riskier nature.
