Unraveling the Value Premium: A Reward for Risk or Mispricing?

Abstract

A value investing strategy consists of purchasing stocks relatively undervalued to their fundamental values and selling those relatively overvalued. Finding this kind of companies has been one of the most challenging goals for investors throughout the history. The main objective of this paper is to test the value factor, but not limited to the traditional Price-To-Book ratio, but exploring diverse alternatives constructed on different metrics in order to determine if it possible to obtain excess returns relative to the traditional one. In addition, these factors were blended different quality factors. First, we tested the so-called high mispricing portfolios, with long positions in value/high quality stocks and short positions in growth/low quality stocks. When blend-ing these portfolios with quality factors, we observe quite an improvement in terms of Sharpe Ratio and maximum draw downs relative to pure value portfolios. In this case, we see that ex-cluding riskier low-quality stocks reduces the overall risk of the portfolio. Regarding the low mispricing portfolio, the results show that growth/high quality stocks outperform value/low quality stocks. This is consistent with the hypothesis of behavioral-based theories as we see that only undervalued and high-quality stocks generate excess returns. Finally, we test the results against the three-factor Fama-French models, achieving statistically significant alphas in some cases.

Keywords: Factor Investing, Factor Models, Quality Factor, Excess Returns, Value Investing

JEL Classification: C1, C3, N2, G11