Abstract

The value anomaly arises naturally in the neoclassical framework with rational expectations. Costly reversibility and countercyclical price of risk cause assets in place to be harder to reduce, and hence are riskier than growth options especially in bad times when the price of risk is high. By linking risk and expected returns to economic primitives, such as tastes and technology, my model generates many empirical regularities in the cross-section of returns; it also yields an array of new refutable hypotheses providing fresh directions for future empirical research.

Scientific Portfolio AI- Generated Summary

“The Value Premium” by Lu Zhang is a paper that investigates the economic determinants of risk and expected return within a neoclassical framework of industry equilibrium augmented with capital investment and aggregate uncertainty. The paper proposes a new rationalization for the value premium puzzle, which refers to the coexistence of a high return dispersion and a low unconditional beta dispersion between value and growth stocks.

The paper argues that due to asymmetry in capital adjustment cost, assets-in-place are much riskier than growth options in bad times, while growth options are riskier than assets-in-place only in good times and to a lesser extent. Coupled with a time-varying price of risk, this mechanism goes a long way in explaining the value premium puzzle.

The paper offers detailed simulation evidence confirming that the aforementioned economic mechanism is indeed the driving force behind the value premium generated in the model. The paper investigates the productivity differences between value and growth, and shows how these differences lead to different optimal investment behavior, which in turn gives rise to differential patterns of risk and expected return across the business cycles.

The paper also yields an array of new predictions that may provide new directions for empirical research on the cross-section of returns. These predictions include: (i) value factor in capital investment, i.e., value firms scrap more capital and face higher adjustment cost in bad times and growth firms expand more in good times; (ii) predictability and cyclical properties of value-minus-growth return; (iii) a cross-industry positive relation between the degree of asymmetry and the value premium and spread (or Tobin’s Q) within the industry; (iv) a positive correlation between industry return and the dispersions of firm characteristics within the industry; and (v) the differential response of dividend yields to firm-level and aggregate shocks across small and large firms.

Overall, it makes a significant contribution to the rational asset pricing literature by proposing a new mechanism for explaining the value premium puzzle and offering new testable predictions for empirical research. The paper’s methodology and findings have important implications for investors, policymakers, and researchers interested in understanding the cross-section of returns and the factors that drive risk and expected return in financial markets.