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Diamond Rough
Investing | Peer-Reviewed Research

Diamond In The Rough

Mining The Possibilities Of Value Stocks

Based on research by Yuhang Xing , Huseyin Gulen and Lu Zhang

Mining The Possibilities Of Value Stocks

  • Value stocks are company shares that investors think are underpriced. They’ve historically performed better than another popular investment type, known as growth stocks. 
  • Value stock portfolios respond more to market volatility than do growth portfolios, but they act similarly to growth stocks when markets are calm.
  • Because market volatility often occurs during economic downturns, value stocks may be riskier during such periods. On the other hand, value stocks also have more upside potential at these times, because the market rewards risk.

Value stocks are Wall Street’s Two-Buck Chuck. They’re shares that investors think deserve a higher price based on a firm’s sales, profits or other fundamental characteristics. 

Growth stocks, on the other hand, seldom show up on the bargain table. Even so, they often lure investors, who bet their prices will rise even more as the companies expand. While both types are popular investments, the less-glamorous value stocks historically get better over time. 

The performance gap between the two investment types is called the “value premium.”  In a recent study, Rice Business Professor Yuhang Xing joined two other finance scholars, Huseyin Gulen of Purdue University and Lu Zhang of Ohio State University, to review a half-century of data and calculated that the monthly value premium averaged 0.39 percent. They think they know why.  

In a multifaceted statistical study, the research team found that value shares are more sensitive to turbulence in the market than are growth stocks.

Every time the stock market looks stormy, value stocks get riskier. But because financial risk also carries the tantalizing whiff of higher returns, value stocks that weather such storms perform quite well. Growth stocks didn’t show the same sensitivity during such markets — and neither type of stock showed such sensitivity when the markets were placid.

To draw their conclusions, the scholars used a statistical method called a Markov process, which views data over time and through varying conditions called states — in this instance, periods of high or low market volatility. The researchers based their model on a study from 2000 that took a similar mathematical approach but asked different questions.

Xing and her colleagues then analyzed the performance of value and growth stock portfolios in each of the 648 months from January 1954 through December 2007. The start time was significant: January 1954 was the effective date of a policy that allowed U.S. Treasury interest rates to rise and fall with the market. The professors used the Treasury rates starting that month as a thermometer for measuring market volatility.

They found a correlation between high market volatility and recession and between low market volatility and economic expansion. The link wasn’t perfect, but occurred often enough for Xing’s team to conclude that economic slumps affect value stocks more than growth stocks

The researchers also used one-month Treasury bill rates as one of several benchmarks for assessing how growth and value stocks performed. These rates are a favorite of financial professionals who are calculating returns on risk-free investments, because the U.S. government backs the nation’s debt. (Treasury bills are loans to the government for a year or less.) Investors can lend with the confidence that Uncle Sam will pay them back with interest — though not much interest, because of Treasury bills’ low risk. T-bills currently pay around 1 percent annually, according to, the official website for purchasing Treasury securities. 

Logic dictates that stocks are riskier than Treasury securities, because share prices wax and wane with firm performance, the market and the economy. So why do value portfolios outperform portfolios with growth stocks?

The answer: Value companies often are established players in mature industries. Many distribute some of their profit to investors through quarterly dividends. They’re a bit like a bargain wine from the grocery store — adequate, if unglamorous.

Growth companies, meanwhile, typically invest most of their income in expansion and product development rather than paying out dividends. They often offer breakthrough technical devices or innovative services.

Earlier research suggests that because value companies typically are better established than growth firms, they are less nimble in responding to worsening economic conditions. The value of their financial and physical assets, which accountants call book value, stays about the same. But their market value — the sum price of all a firm’s outstanding shares — falls because of their potential for sluggish response to hard times. 

At that point, like a not-so-fancy bottle of wine, value stocks live up to their name. Labels aside, investors think they’re worth more than they cost.

Yuhang Xing is an associate professor of finance at Jones Graduate School of Business at Rice University.

To learn more, please see: Gulen, H., Xing, Y., & Zhang, L. (2011). Value versus growth: Time-varying expected stock returns. Financial Management, 40(2), 381-407.

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