Which cheap (high book-to-market value) stocks drive the value premium? Can investors capture the value premium by simply buying a broad index of value stocks, or should they focus on some easily identifiable subset. The paper “Institutional Ownership and the Value Premium” by Ludovic Phalippou from April 2005 evaluates level of institutional ownership as the driver of the value premium, hypothesizing that mispricing of stocks is mostly like to come from unsophisticated individual investors. Using data for 1980-2001, he concludes that:
- Stocks least held by institutional investors (comprising just 7% of total stock market capitalization) drive the value premium. Stocks most held by institutional investors exhibit no significant value premium.
- In fact, the value premium for the 10% of stocks with the lowest institutional ownership is about 2% per month.
- The level of institutional ownership is much more important in driving the value premium than: (1) firm size; (2) idiosyncratic volatility of the stock; or, (3) number of analysts following the stock.
- The level of (sophisticated and informed) institutional ownership is strongly and negatively related to initial mispricing, costs of arbitrage and the sluggish incorporation of information into stock price.
- The value premium likely devolves from the tendency of some (excitable individual) investors to misprice stocks that are costly to arbitrage.
The following chart, taken from the paper, shows the average difference between the monthly (equally-weighted) returns of value and growth stocks for all institutional ownership (IO) deciles. It shows that there is a consistent, negative relationship between the degree of institutional ownership and the value premium.
In summary, capturing the value premium means focusing on stocks with the lowest institutional ownership.
