The Value Factor: Why Cheap Stocks Outperform Expensive Stocks Over Time

How the Value Factor Is Measured

The value factor is typically measured using price-to-book (P/B) ratio — the ratio of a company's market capitalization to its book value (assets minus liabilities). Fama and French used P/B in their original 1992 paper, sorting stocks into deciles based on P/B and finding that the lowest P/B decile outperformed the highest P/B decile by 1.5% per month. Modern value factor definitions use multiple ratios: price-to-earnings (P/E), price-to-sales (P/S), price-to-cash-flow (P/CF), and enterprise value to EBITDA (EV/EBITDA). Academic research suggests that a composite value score using multiple ratios produces a stronger and more consistent value premium than any single ratio. The value factor is strongest among small-cap stocks and weakest among mega-cap stocks. Small-cap value has the highest historical premium of any factor combination at 4-6% annually. Small-cap investing and the size premium →

Why Does the Value Premium Exist?

There are two main explanations for the value premium. The risk-based explanation: value stocks are riskier than growth stocks because they tend to be distressed companies with weak earnings, high leverage, and uncertain futures. Investors demand a premium for bearing this distress risk. The behavioral explanation: investors systematically overextrapolate past growth into the future, causing growth stocks to become overpriced and value stocks to become underpriced. When the overpriced growth stocks disappoint and the underpriced value stocks recover, the premium emerges. Research supports both explanations — value stocks do have higher distress risk, and investors do exhibit extrapolation bias. The premium is likely a combination of both factors. The behavioral component explains why value tends to work best after periods of extreme growth stock outperformance, when extrapolation bias is strongest. Behavioral finance biases in investing →

The Lost Decade: Value 2007-2020

The period from 2007 to 2020 was the worst in history for the value factor. Value underperformed growth by approximately 6% annually — a devastating 13-year drawdown. An investor who put $100,000 in value stocks in 2007 would have had $180,000 by 2020. The same investment in growth stocks would have grown to $380,000. This period was driven by several factors: the rise of technology companies (which tend to be growth stocks), the decline of traditional value sectors (financials, energy, industrials), ultra-low interest rates that disproportionately benefited long-duration growth stocks, and the increasing importance of intangible assets that are not captured by traditional value metrics. The value factor was widely declared dead by market commentators. Many investors abandoned value right at the bottom. Starting in 2021, value staged a dramatic recovery, outperforming growth by 7% annually from 2021 to 2023. The lesson is that value cycles through extended periods of outperformance and underperformance, and the key to capturing the premium is staying invested through the painful periods.

Implementing the Value Factor Today

Investors can implement the value factor through value ETFs. The largest options: VTV (Vanguard Value ETF, 0.04% ER) tracking the CRSP US Large Cap Value Index, IWD (iShares Russell 1000 Value ETF, 0.19% ER), and IWN (iShares Russell 2000 Value ETF, 0.24% ER) for small-cap value. For deeper value exposure, AVUV (Avantis US Small Cap Value ETF, 0.25% ER) uses a multi-dimensional value screen and adds a profitability filter. DEEP (Roundhill Acquirers Deep Value ETF, 0.80% ER) targets deeply undervalued stocks. Research from Dimensional Fund Advisors shows that combining value with profitability screens significantly improves the value premium by filtering out distressed companies that are cheap for good reason. The best implementation for most investors is a combination of VTV or IWD for large-cap value and AVUV for small-cap value, held in tax-advantaged accounts for better tax efficiency. Factor investing ETFs detailed comparison →

What is the value factor premium?

The value factor premium is the historical outperformance of cheap stocks (low P/B, P/E, P/S) over expensive stocks. Fama and French documented a premium of 4-5% annually from 1963 to 2023 using US data. The premium has been confirmed in 50+ countries globally. The premium varies over time — it can disappear or reverse for extended periods (as it did from 2007-2020), which is why capturing it requires patience and discipline.

Why did value underperform for so long?

Value underperformed from 2007-2020 due to the rise of technology companies (growth stocks), declining traditional value sectors, ultra-low interest rates that benefited growth stocks, and the growing importance of intangible assets not captured by traditional value metrics. These factors created a perfect storm against value. The period was historically anomalous — no other 13-year period in the data shows such extreme value underperformance.

How do you invest in the value factor?

Invest in the value factor through value ETFs like VTV (large-cap value, 0.04% ER), IWD (large-cap value, 0.19% ER), or AVUV (small-cap value, 0.25% ER). Simple approach: allocate 50% VOO (S&P 500), 25% VTV, 25% AVUV. Rebalance annually. Hold in tax-advantaged accounts if possible. Do not try to time value cycles — the premium only works if you hold through underperformance periods.

Is the value factor dead?

The value factor is not dead, despite frequent declarations to the contrary. The 2007-2020 underperformance was severe, but value has recovered strongly since 2021. Academic research shows the value premium persists across time and markets. The factor may have weakened (from 4-5% to perhaps 2-3% annually) due to increased awareness and lower trading costs, but it has not disappeared. The risk-based explanation suggests the premium will persist as long as value stocks carry higher distress risk. The behavioral explanation suggests it will persist as long as investors extrapolate past growth too far into the future.

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