UConn Assistant Professor of Finance Fan Yang, and colleagues, have developed a new model that offers an explanation of how value stocks can outperform others.

“While our theory is new, this puzzle [the value premium] has been identified for decades,” said Fan, who has been researching this trend since 2012. “Value firms are less flexible than growth firms in switching to debt financing when equity financing is costly. This makes them more risky and, hence, offer a higher risk premium.”

“Our research provides a rational explanation for the value premium. It can also explain the outperformance of stocks with low physical investment rates,” he said. “The idea of equity financing shock was inspired by the 2008 financial crisis in which an aggregate shock originated from the financial sector impacted the real sector and asset prices.”

The findings, in a paper titled, “External Equity Financing Shocks, Financial Flows and Asset Prices,” is pending publication in the journal Review of Financial Studies. Yang collaborated with Frederico Belo, from INSEAD, and Xiaoji Lin, from the University of Minnesota.

“We have worked hard for a very long time on this paper, presenting our initial findings in conferences in 2014 and 2015,” Yang said. “We’ve gotten very positive feedback. It’s very exciting to be able to offer a single explanation based on financial shocks for a couple of important anomalies in financial markets.”

The researchers developed a dynamic model with time variation in external equity financing costs and showed that variation in these costs is important for the model to quantitatively capture the joint dynamics of firms’ asset prices, real quantities and financial flows in the U.S. economy.

In the model, growth/high investment firms are less risky in equilibrium because they can more easily substitute debt financing for equity financing when it becomes more costly to raise external equity, which are bad economic times, Yang said. Investors, who are risk-averse in general, are more willing to buy these less risky stocks. The high demand for these stocks drives up their stock prices and lowers their stock risk premiums.

Fan and his colleagues use the model to estimate an empirical proxy of aggregate equity issuance cost shock (ICS) in the U.S. economy from 1964 until 2013.
They provided empirical support for the models’ assumptions and economic mechanism. They also showed that the equity ICS captures an important dimension of systemic risks in the economy, and carries a positive price of risk. Assets with returns that co-vary less with equity ICS, such as growth and high investment firms, have lower risk, and therefore lower average returns in equilibrium.

Their results have implications for asset pricing, corporate finance and macroeconomics literature, Yang explained. The findings suggest that time-variation in the aggregate cost of external equity financing has a significant impact on asset prices, real quantities and financial flows. By affecting firms’ investment and financing decisions, these shocks are likely to affect aggregate quantities as well.

Going forward, incorporating aggregate shocks to the cost of external equity financing in current dynamic stochastic general equilibrium models may be important for an accurate understanding of aggregate quantity dynamics, time-varying risk premiums and financial flows over the business cycle, Yang said.