Deep Value

Abstract

The authors define deep value as episodes in which the valuation spread between cheap and expensive securities is especially wide relative to its history. Examining global individual equities, equity index futures, currencies, and global bonds, the authors find that deep value is (1) highly compensated; (2) related to worsening fundamentals; (3) associated with higher risk but not fully explained by known risk factors; and (4) characterized by selling pressure related to overextrapolation of past returns and, although arbitrageurs take the other side, they face elevated trading costs and risk. These findings support a theory of return extrapolation driving the value risk premium over other behavioral and rational explanations.

TOPICS: Developed, portfolio construction, risk management, quantitative methods

Key Findings

• ▪ The evolution of asset returns and fundamentals around deep value episodes—defined as periods with an especially wide valuation spread between cheap and expensive securities—offers a new window to understand markets and differentiate competing theories of the value premium.

• ▪ Deep value episodes have historically been characterized by poor past performance of value investing and high future returns to value investing.

• ▪ During these episodes, value stocks experience worsening earnings fundamentals, negative sentiment in news stories, selling pressure, and higher limits to arbitrage; nevertheless, sophisticated arbitrageurs pursue these opportunities.