The value effect is the tendency of value stocks to outperform the market in the long term.
A number of explanations have been suggested for the value effect. These include
- It is a compensation for risk.
- It is a genuine effect, but can be explained by Q-theory
- Undervalued shares necessarily trade at a lower rating than overvalued shares.
- Investors over-react (over-value or over-estimate) growth.
The first of these is not particularly interesting, as investors have better ways to exchange risk for returns. It is also not too difficult for investors to calculate Q for themselves and directly invest in low Q companies. One study did find that Q-theory can fully explain the value effect.
The last two do suggest that there is a genuine mis-pricing that investors can exploit, and some studies have found evidence that investor over-reaction does occur.
Over-reaction is one possible source of valuation errors, but any type of valuation error means that the undervalued shares trade at lower ratings than overvalued shares. If undervalued shares have low ratings and overvalued shares have high ratings, then shares with low ratings and more likely to be undervalued while those with high ratings are more likely to be overvalued.
There is also evidence that the strength of the value effect varies from sector to sector, being strongest in value sectors and weakest in growth sectors. In addition, there is a sector value effect, even though this is weaker than the company level value effect.
It has also been claimed that the value effect applies at a country level, so investing in fast growing countries with high market PEs (i.e. emerging markers) will under-perform investing in markets with low market PEs.