The Existence, Characteristics And Explanations Of Chinese Stock Market’s Value Premium

The value premium refers that the return of value stock is higher than that of growth stock. As a market anomaly, its empirical research and formation mechanism become the focus of investors and researchers.According to the risk pricing theory in traditional finance, the value premium may be due to the higher risk of value stocks than growth stocks. However, according to the behavioral finance, the formation of the value premium may be due to investors’ overreaction bias. Doing researches on issues related to the value premium, will not only help equity investors to make specific value investment decisions in practice, but also help to test the usefulness and limitations of traditional finance theory and behavioral finance theories in interpreting market phenomenon.The existence of value premium of Chinese stock market has been confirmed. However, its characteristics haven’t been studied in detail by researchers, and the reason of the premium is still a controversial issue in our country.Based on all the A-share stocks of China’s Shanghai Stock Market and Shenzhen Stock Market in period of January 1997 to March 2014, this thesis using methods such as portfolio spreads method, Markova regime switching model, different forms of GARCH models, regression analysis method and so on, to do a comprehensive and detailed research on the value premium of Chinese stock market. This thesis firstly examines the existence of value premium in Chinese stock market, and then investigates the characteristics of value premium from the perspective of a comparative analysis between American and Chinese stock market. On the characteristics of value premium, this thesis mainly analyzes the different practical guidance effect of PB、PE、PS and PC, the relationship of value premium and the investment period, the performance of value strategy in the large cap stocks and small cap stocks, the time-varying and cyclical features of value premium. When it comes to the causes of value premium, thisthesis launches the research both from the perspective of risk view and the perspective of behavioral view.The main research contents and conclusions can be summarized as follows:Firstly, this thesis examines the existence of Chinese stock market’s value premium using empirical test method. Specifically, using all the A-shares stocks as the research sample, discriminating value and growth stocks depending on PB、PE、PS and PC respectively, employing portfolio spreads method to explore the different performance of value and growth portfolios, our empirical results show that the value premium do exist in Chinese stock market, which indicating that value investment strategy is effective in Chinese stock market.Secondly, from the perspective of a comparative analysis between American and Chinese stock market, this thesis investigates the characteristics of value premium from different angles.We already know that the value investment strategy is effective, but only having knowledge about that is not enough, for it cannot help academic researchers to deeply understand issues about the value premium, and cannot provide specific investment guidance for the market participants. In order to further investigate the value premium, we make a comprehensive investigation on the features of value premium, and also make a comparison about each feature of value premium between American and Chinese stock market, which helping Chinese investors searching suitable methods when using value investment strategy. Specifically, this thesis analyzes the value premium features from five aspects; the main conclusions are as follows:(1) Four ratios such as PB、PE、PS and PC, all have guiding significance for the value investment practice, but by way of contrast, the value premium based on PB and PS is higher than that of PE and PC,indicating that PB and PS is more useful in distinguishing value and growth stocks in practice than PE and PC and thus have higher guidance value;(2) In Chinese stock market, it is not right to holding arbitrage portfolio as long as possible when using value investment strategy, our empirical results show that holding arbitrage portfolio one or two years is the best choice, for when the holding period is longer than two years, the average value premium in the holding period becomes lower;(3) The value premium of large cap stock is higher than that of small cap stock, meaning that value investment strategy is more suitable for large cap stocks;(4)In the seventeen industries of our country, most industries show value premium phenomenon, but the value premium of mining industry, financial industry, water environment and public facilities management industry is low or negative, implying that value investment is not suitable for these industries;(5)The value premium is time-varying and has different performance in different regimes, it is higher in bull market than that in bear market and is higher in high volatility period than that in low volatility period.Thirdly, based on a variety of risk metrics, this thesis explores the causes of value premium of Chinese stock marketfrom the perspective of risk. According to the risk compensation pricing theory of the traditional finance, the return of stock is positively related to its risk, the higher its risk, the higher its return. The persistent existence of value premium shows that the return of value stock is higher than that of growth stock, in order to test whether risk factors can explain the differences of returns of value stock and growth stock, the paper first investigates the risks of value and growth stock from time-varying market risk and time-varying market volatility risk respectively, then investigate the dynamic risk of value investment strategy using a Markova regime switching model which includes several kinds of risk measures. Our empirical results find that in consideration of the time-varying nature of risk, the risk of value stock is not higher than that of growth stock, so risk factors cannot explain value stock’s better performance, that is to say, the risk pricing theory cannot explain the value premium of Chinese stock market.Forthly, based on return reversals, this thesis explores the causes of value premium of Chinese stock marketfrom the perspective of behavior biases.For risk factors cannot explain the value premium, we try to analyze the causes of value premium from other angles. Behavioral finance points out that the anomalies in the market are often associated with investor’s psychological factors and irrational behaviors. For example, Lakonishok et.al (1994) believes that American stock market’s value premium is related to investor’s overreaction. In our thesis, we first compare the performance of stock portfolios between formation period and test period according to De Bondt and Thaler (1985)’s method; the empirical results show that the returns of value stock, growth stock and arbitrage portfolio after the portfolio construction point all experience great reverse compared to the returns before portfolio construction point; the performance of value stock is poor in the past but is good in the future, otherwise the performance of growth stock is good in the past but is bad in the future, the return of arbitrage portfolio is negative before portfolio construction point but became positive after portfolio construction point. Subsequently, based on the expanded DHS model, this thesis analyzes the deep-seated reasons behind the return reversals, and tries to explain the value premium from the angle of behavioral biases. Our results find that the formation of value premium is related to the return reverse process, and the time-varying characteristic of value premium is attributed to the time-varying speed of return reversals; when the noise volatility in the market is high or when the market noisy information is consistent with investors’ prior belief, the return reversals of value and growth stock will speed up, thus producing or pushing up the value premium, and investor s’ overconfidence and self-attribution bias plays an important role in this process.Compared with the domestic researches in the past, the main contribution of this thesis is as follows:Firstly, the existing research in China does not examine the characteristics of value premium, but we study this in great detail. Studies in the past mainly test the existence of value premium, but this kind of research is too general to help researchers understanding the issues related to value premium in depth and to guide the actual investment activities of market participants effectively. In order to make up for this research gaps, this thesis not only tests the existence of the value premium, but also investigates the characteristics of value premium. In addition, we make a comparison on each characteristic between Chinese stock market and American stock market, this kind of comparison not only helping to deepen researchers’understanding of the Chinese market, but also avoiding academics and investors using foreign countries’ research conclusions uncritically.Secondly, this thesis uses several kinds of risk measures to analyze risk of value and growth stock, thus avoiding limitations of single risk indicators.We also take into account the time-varying nature of risk, making the conclusions more reliable. The existing researches mainly analyze the risk of stocks according to the market systemic risk (beta), but ignore the time-varying nature of risk, which is inconsistent with the real world. The existing researches also ignore some other risk factors, such as market volatility risk, skewness risk, downside risk, and so on. That makes the analysis from risk prospective not comprehensive enough. This article anylize the time-varying risks of value investment base on multiple risk metrics, and examines the risk explanation of value premium in a more comprehensive way.Thirdly, this thesis extends the existing conclusions in the present behavioral finance articles. The present literature associated with behavioral finance suggests that value premium is due to over-reaction, but doesn’t directly study the logic relationship between value premium and over-reaction.This thesis argues that the formation of value premiums is related to return reversals, and analyzes the underlying causes behind return reversals. That is, we suggest an explanation for value premium through the idea that behavioral biases affect return reversals and thereby affect value premium.Forthly, this thesis also makes some improvements in data processing methods, making sure that the empirical results of this thesis more accurate. For example, the frequency of constructing stock portfolios in the past literatureis once a year, but we construct stock portfolios each month to cover more information in one whole year. When analyzing the performance of value stock, growth stock and arbitrage portfolios, we need calculate the holding period return according to raw monthly returns.In this thesis, we use buy-and-holding return other than cumulative return most literature using to measure portfolio’s future returns. Because the cumulative return measure could overestimate portfolio’s future returns, when the volatility is high. Last, all the analysis in this thesis are based on PB, PE, PS and PC, making sure that the conclusion is more universal compared with the existing literature which use only a single indicator.