Essays on the Riskiness of Value Stocks
Value Stocks Are Riskier: I propose a risk-based explanation of the value premium in which there are two components of the equity risk premium; a larger premium to compensate for near-term systematic casflow risk and a smaller one for distant cashflow risks. I hypothesize that value stocks have higher sensitivity to near-term cashflows, and are discounted accordingly. I show how a representative agent with Epstein Zin preferences prices risky assets based on their exposures to innovations in near-term consumption growth and also innovations in anticipated future consumption growth (or wealth). In this economy, the SDF is high when near-term consumption is shocked negatively, and also when wealth is negatively shocked for other reasons. I hypothesize that negative near-term cashflow shocks bring low payoffs for value stocks due to their high cashflow elasticity of price (i.e., both their cashflows and market-to-cashflow ratio can decline in response to the aggregate shock). In contrast, the cashflows and multiples of growth stocks have a hedging quality that makes them less sensitive to near-term aggregate shocks. The high market-to-cashflow multiple of growth stocks largely reflects expectations of, and discount rates applied to, distant, rather than near-term, cashflows. Their higher equity duration shields them from near-term cashflow shocks. In addition, the cashflows of growth stocks may also vary with non-systematic, idiosyncratic factors.
To test these ideas, I develop an exactly-solved linear present value model of the price-dividend ratio which disentangles near-term cashflows from expected future cashflow growth with two time-varying risk premia. I use an Unscented Kalman Filter and Maximum Likelihood optimization to estimate the model on a long history of US market data. I find evidence that supports the existence of two different risk premia, with the premium for near-term cashflow risks being larger. I measure the sensitivity of value and growth stocks to the estimated premia and find that (a) the expected returns of value stocks have higher loadings on the larger risk premium, and (b) unexpected value returns are more sensitive to near-term cashflow shocks. In this sense, value stocks are more prone to cashflow, and price, declines during (and in anticipation of) recessions when they become riskiest and discount rates are high. Growth stocks are less risky during recessions but become most sensitive to shocks during booms, when discount rates are low.
Value Stocks Are Riskier (part II): In O'Neill (2022), I proposed a risk-based explanation of the value premium in which there are two components of the equity risk premium; a large premium to compensate for near-term systematic cashflow risk and a smaller one for distant cashflow risks. I found evidence of this dual risk premium structure in historical aggregate stock prices, and that value stocks are more highly sensitive to near-term cashflow risks than growth stocks and are discounted accordingly. In this paper, I cultivate this risk-based explanation by parsing the principal reasons that near-term cashflow shocks are especially threatening to value stocks. In particular, I argue that value stocks cashflows (as well as prices) have high shock sensitivity, which can be attributed to specific innate firm characteristics. First, I relate the risk premium for near-term cashflow shocks to an original asset risk measure, the Cashflow Shock Elasticity of Price, and I show that portfolios of value stocks have a larger shock elasticity than growth stock portfolios (mainly due to the outsized response of portfolio cashflows to aggregate shocks). Second, using a comparative static model of the firm, I identify the firm-level fundamental determinants of outsized shock elasticity (i.e., revenue beta, operating financial leverage, and low profit margins) and I show that these attributes are more abundant in value firms than growth firms. Together with the findings in O'Neill (2022), the results here show that value stocks possess inherent fundamental traits that cause them to be highly sensitive to aggregate cashflow events, which renders them poor economic hedges for investors at inopportune times and therefore riskier, and more discounted.
Supervisor: Laurent Calvet, EDHEC Business School
External reviewer: John Y. Campbell, Harvard University
Other committee members: Emmanuel Jurczenko and Enrique Schroth, EDHEC Business School