Academics have long argued that investors should rationally expect to be compensated for the risk of owning stocks. The higher a company’s perceived risk, the higher a rate of return investors expect. In demanding higher returns, investors pay lower prices for a company’s stock, relative to its earnings, cash flow, or other fundamental measure. Paying lower prices, the theory goes, paves the way for higher future returns.
Historically, evidence supports this theory. Since 1927, large-cap value stocks in the United States have returned 11.1% per year, while large-cap growth stocks have delivered 9.4%. Among small caps, the performance advantage of value has been even greater. Small-cap value stocks have returned 14% per year while their growth counterparts have returned 9.2%.1
Source: O Value, Where Art Thou