The existence of the value premium on the Johannesburg Stock Exchange from 1972 to 2001 and extrapolation as explanation

Abstract

This study investigates the existence of the value premium in South Africa's equity market, and tests extrapolation as a possible explanation for it. The value premium refers to the widely reported superior performance of share price returns of value companies compared to growth companies. The value premium represents an anomaly in mainstream rational finance theory, because it should not persist, unless it could be explained as the result of some composite form of risk. What is highly vexing is the fact that the value premium not only persists in most financial markets over a long period, but that the risk explanation cannot be upheld convincingly. This contributed to the rise of behavioral finance, an approach which introduces psychological factors to provide new explanations for financial phenomena. The behavioral finance explanation for the value premium observation is extrapolation (the tendency to project recent experience too far into the future). This study applies propositions and methods from behavioral finance to investigate the South African equity market. The existence of a value premium in South Africa was investigated by using twenty-nine years' worth of accounting and share price data. The study employed one- and two-dimensional tests for portfolio formation, and tracked share price returns for up to five years after portfolio formation. The results indicated that a statistically and economically significant value premium existed in South Africa for the period between 1972 and 2001. Extrapolation as a potential explanation for the value premium observation was investigated by applying internationally used methods. Extrapolation was found to provide a robust explanation for the South African value premium.