An Evolutionary Explanation of the Value Premium Puzzle

As early as 1934 Graham and Dodd conjectured that excess returns from value investment originate from a tendency of markets to converge towards fundamental values. This paper confirms their insights theoretically within the evolutionary finance model of Evstigneev, Hens, and Schenk-Hopp (2006) as well as empirically using stock price data from the Dow. The analytical result suggests a cross-sectional relation between relative market capitalizations and relative dividends. The corresponding regression line determined in our empirical study beats the security market line (SML) of the CAPM in the goodness of fit as well as a "center of gravity" in the sense of Litterman (2003). Misvaluations have indeed predictive power for the cross-sectional regression proposed here whereas, when being based on the SML, regressions might result in flawed investment advice.