Value Stocks and Superior Returns

Stocks that exhibit low P/B and low PE ratios are often called value stocks.

Those with high PE and P/B ratios are called growth stocks.

Prior to the 1980s, value stocks often were called cyclic stocks because low PE stocks often were found in industries whose profits were tied closely to the business cycle. With the growth of style investing, equity managers who specialised in these stocks were uncomfortable with the cyclic moniker and greatly preferred the term value.

• Value stocks are concentrated in oil, motor, finance and most utilities.
  
• Growth stocks are concentrated in the high-technology industries such as drugs, telecommunications, and computers.
  
• Of the 10 largest U.S. based corporations at the end of 2001, 7 can be regarded as growth stocks (GE, Microsoft, Pfizer, Wal-Mart, Intel, IBM, and Johnson & Johnson), whereas only 2 (Exxon Mobil and Citigroup) are value stocks; AIG can go either way depending on the criteria used for selection.

A study summarising the compound annual returns on stocks from 1963 through 2000 ranked on the basis of both capitalization and book-to-market ratios appear to confirm Graham and Dodd's emphasis on value-based investing.

• Historical returns on value stocks have surpassed those of growth stocks, and this outperformance is especially true among smaller stocks.
• The smallest value stocks returned 23.26% per year, the highest of any of the 25 categories analysed, whereas the smallest growth stocks returned only 6.41%, the lowest of any category.
• As firms become larger, the difference between the returns on value and growth stocks becomes much smaller.
• The largest value stocks returned 13.59% per year, whereas the largest growth stocks returned about 10.28%.

One theory about why growth stocks have underperformed value stocks is behavioural: Investors get overexcited about the growth prospects of firms with rapidly rising earnings and bid them up excessively. "Story book stocks" such as Intel or Microsoft, which in the past provided fantastic returns, capture the fancy of investors, whereas firms providing solid earnings with unexciting growth rates are neglected.

Another more economically based reason is that value stocks have higher dividends, and dividends are taxed at a higher rate than capital gains. As a result, value stocks must have higher returns to compensate for their higher taxability. However, tax factors cannot explain the wide spreads between small value and growth stocks.

The differences in the return between large growth and large value stocks appears to wax and wane over long cycles.

• Growth stocks gained in the late 1960s and peaked in December 1972, when the "nifty fifty" hit their highs.
• When investors dumped the nifty fifty, growth stocks went into a long bear market relative to value stocks. One of the reasons for this was the surge in oil stocks, which are classified as value stocks, when OPEC caused petroleum prices to soar.
• From 1982 onward, growth stocks gained relative to value stocks, soaring in the technology boom of 1990-2000, only to fall again when the euphoria subsided.
• In fact, large growth stocks have outperformed large value stocks in about half the years since 1963.

BARRA, Inc., a California-based stock research firm, has divided the firms in the S&P 500 Stock Index into two groups of growth and value stocks with equal value on the basis of the firm's market-to-book ratio. Using the ratio of the cumulative return on these two large capitalization growth and value indexes since Dec 31, 1974, when the indexes were first formulated:

• On the basis of capital appreciation alone, growth stocks, with a 11.06% annual return, beat value stocks by 0.31% over this 37-year period.
• However, these value stocks have dividend yields that are about 2 % above that of growth stocks. When dividend yields are included to find total cumulative returns, value stocks' return of 15.6% per year outperformed growth stocks by about 1.9%.
• However, for taxable investors, the difference between the cumulative returns on S&P growth and value stocks has been very slight over the past 27 years, a difference of only 0.69%.

Furthermore, the unprecedented volatility of growth stocks relative to value stocks in recent years has played havoc with historical data.

• For someone who began investing in 1975, the technology bubble of the late 1990s sent after-tax growth returns higher than after-tax value returns from September 1999 through September 2000.
• Once the bubble popped, however, growth stock returns fell back below those of value stocks very quickly.

It should be noted that beginning the growth and value series in 1975 is very favourable for value stocks.

• Large value stocks crushed large growth stocks from 1975 through 1977, when soaring oil prices sent the price of oil and resource firms (which are always ranked as value stocks) skyrocketing.
• Since August 1982, when the great bull market began, cumulative returns for growth and value investors have been almost identiacal, even after the growth stock collapse of 2000-2001.

Also read:

Nature of Growth and Value Stocks

Nature of Growth and Value Stocks

These designations are not inherent in the products the firms make or the industries they are in. The terms depend solely on the market value of the firm relative to some fundamental variable, such as earnings, book value, etc.

The stock of a producer of technology equipment, which is considered to be an industry with high growth prospects, actually could be classified as a value stock if it is out of favor with the market and sells for a low market-to-book ratio.

Alternatively, the stock of an automobile manufacturer, which is a relatively mature indsutry with limited growth potential, could be classified a growth stock if its stock is in favor.

In fact, over time, many stocks go through value and growth designations as their market price fluctuates.

The literature often showed value stocks beating growth stocks. What does this mean?

• As many stocks go through value and growth designations as their market price fluctuates, this implies that stocks become priced too high or low because of unfounded optimism or pessimism and eventually will return to true economic value.
• It definitely does not mean that industries normally designated as growth industries will underperform those designated as value industries.

There is no question that investors always should be concerned with valuation, no matter which stocks they buy.