The impact of business cycle in value investing

Abstract

The spread between value and growth (also called the value premium) is one of the best accepted iterations of a market anomaly, however the reasons for the over performance of value portfolios over growth portfolios is still a source of debate. The nature of the risk that value stocks bear is often related to the fact that these companies have high ratios of fixed assets and thus, are less flexible than growth stocks in making adjustments during recessions.

The aim of this thesis is to contribute to the existing corpus of literature by identifying which macroeconomic factors have an impact on the value premium. This thesis tries to answer two main questions. First, can the value premium be explained by the business cycle risk? Second, do macroeconomic variables have an impact on the volatility of value, growth, and HML returns? Several econometrics models on the financial time series have been applied to answer these questions.

First, we analyzed the impact over business cycles of a set of macroeconomic variables on the value premium using a Markov Switching model. This model suggests several conclusions. First, that asymmetries can be observed over the business cycles for the value, growth and HML portfolios, meaning that they react differently to changes in economic conditions over to the business cycles. Then, during the economic downturn, value excess returns are more strongly affected compared to growth excess returns by certain macroeconomic factors, specifically the growth rate of gross private domestic investments, the growth rate of gross government investments, the term spread changes, the credit spread changes, the inflation rate, the growth rate of industrial production and the growth rate of the aggregated profits. These provide evidence that the value premium can be further explained by economic fundamentals rather than the behavior of investors. Our results prove that value stocks have to bear the macroeconomic risk and this is consistent with the flexibility hypothesis.

Then, this study identifies a set of macroeconomic factors which influence the prediction of the value and growth excess returns using the elastic net algorithm. These results confirm that macroeconomic factors are drivers of the value premium in both economic downturns as well as upturns.

Finally, using a subset of the data available in a monthly frequency, we have tested the impact of a set of macroeconomic variables on the volatility of value, growth and HML returns through the GARCH-G(1,1) and GARCH-S(1,1) models. The findings have led us to conclude that macroeconomic variables have a significant impact on the value and growth excess returns and therefore, also influence the volatility of the value premium.