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Why Do "Value" Stocks Tend to Come Out Ahead?
by Dave Van Knapp, author of
SENSIBLE STOCK INVESTING:
How to Pick, Value, and Manage Stocks
and
THE TOP 40 DIVIDEND STOCKS FOR 2010:
How to Generate Wealth or Income from Dividend Stocks
August, 2007
Since about 1990, it has been accepted practice in the investing world to divide
stocks into "growth" and "value" categories. Furthermore, over long periods,
value stocks tend to have greater total returns than growth stocks. Warren
Buffett’s empire is built on this fact.
Why is this true? First, let’s define what the terms mean. Value stocks are the
ones that have low Price-to-X ratios, where X may be book value (P/B),
earnings (P/E), or sales (P/S).
Growth stocks generally have high growth rates in things like earnings and sales.
Because of the way the market tends to value stocks, those with high growth
rates also tend to have high Price-to-X ratios. So a value stock may have a P/E
of 15, while a growth stock might have a P/E of 29.
Therefore, a simple and common way to categorize a group of stocks is to rank
them from high to low on a Price-to-X ratio, and then draw a line straight
through the middle of the list. Everything above the line (higher ratios) is
considered a growth stock, everything below the line is considered value.
This is a pretty crude, some might say simplistic, distinction. After all, if you
divide the S&P 500 into two groups as just described, is there that much
difference between the 249th and 250th stocks? Of course not. Yet the first will
be called a growth stock, the second a value stock.
Nevertheless, studies show consistently that value stocks (as a group)
outperform growth stocks over long time periods when all stocks are held for
long periods. For example, between 1983 and 2006, value stocks outperformed
growth stocks in 16 out of the 23 five-year holding periods that ended in those
years. From 1979 through 2006, the Russell 1000 Value Index returned 2.4%
more than the Russell 1000 Growth Index.
Why do value stocks produce higher long-run returns?
There are several reasons:
The first reason derives from the way the two categories are constructed. By
definition, if growth stocks include all stocks above the median Price-to-X ratio
for a given universe of stocks, the growth category will include practically all the
stocks that are overvalued—priced too high compared to where they are likely
to be priced in the future. Investors as a group have a tendency to overestimate
the growth potential—and the time-frame during which fast growth can be
sustained—and therefore tend to overvalue such stocks when they are “hot.”
Over time, the inexorable market forces of rationality and reversion to the mean
will bring these stocks, on average, closer to their true worth. Overvalued stocks
will see their prices reduced (or grow more slowly) in comparison to their value-
stock cousins.
The same principle works in favor of the value stocks. That group, by
definition, contains almost all the stocks that are undervalued. Market
participants as a group tend to underestimate the long-term growth potential of
slower-growing stocks, especially if they are living through a tough patch in their
businesses. So such stocks tend to be undervalued. The same market forces as
previously mentioned will tend to bring the prices of those stocks up relative to
the growth group.
The second reason is a camouflaged outcome of the long-holding-period ground
rule. None of the studies that I have seen consider what happens if an investor
utilizes sell-stops or some other selling discipline to curtail losses on his or her
holdings. Many sensible investors buy growth stocks because they are on a tear,
growing not only their revenues and earnings but also their stock prices. If there
were a law that any stock, once purchased, must be held for five years (the
holding period reflected in the study mentioned earlier), not many rational
investors would participate. It is unreasonable to expect a fast-growth stock to
outperform for five years running. So the rules of the studies are stacked against
growth stocks and in favor of value stocks.
A third reason is that the value group tends to harbor more dividend payers.
Several studies have shown that dividends—especially reinvested dividends—
account for up to half the total return of stocks over long periods of time. So
again, the growth stocks are at a long-term disadvantage compared to the value
stocks.
What are the lessons for the individual investor? To me, there are three:
• It is reasonable to have a “value tilt” to one’s stock holdings. That said,
remember that the value advantage tends to reveal itself over long holding
periods. If long holding periods do not suit your personality, be careful. You will
find it psychologically difficult (or impossible) to hold onto a declining or
“sideways” stock for a long time while you are waiting for the market to figure
out its true value—which may take years. It will feel like "dead money" to you.
Not only that, you may be wrong about the stock’s real potential. Just because a
stock is a value stock does not mean that its price is going to rise. It may have a
justifiably low valuation because it is a lousy stock. Which leads to lesson
number 2:
• Analyze your purchases before making them. Take a holistic approach.
Don’t buy any stock just because it is a value stock, pays a dividend, or for any
other single reason. Know why you are buying a stock before you buy it. Look
at it from multiple perspectives. The crude value-versus-growth categorization is
just a single factor, and perhaps not a very helpful one at that.
• Have an exit strategy. Whether you use sell stops or some other
discipline, you should know under what circumstances you will sell it. If a
growth stock does great for you for a year or two but then goes into reverse,
sell it, unless there are good reasons which you can articulate for holding onto it.
by Dave Van Knapp, author of
SENSIBLE STOCK INVESTING:
How to Pick, Value, and Manage Stocks
and
THE TOP 40 DIVIDEND STOCKS FOR 2010:
How to Generate Wealth or Income from Dividend Stocks
August, 2007
Since about 1990, it has been accepted practice in the investing world to divide
stocks into "growth" and "value" categories. Furthermore, over long periods,
value stocks tend to have greater total returns than growth stocks. Warren
Buffett’s empire is built on this fact.
Why is this true? First, let’s define what the terms mean. Value stocks are the
ones that have low Price-to-X ratios, where X may be book value (P/B),
earnings (P/E), or sales (P/S).
Growth stocks generally have high growth rates in things like earnings and sales.
Because of the way the market tends to value stocks, those with high growth
rates also tend to have high Price-to-X ratios. So a value stock may have a P/E
of 15, while a growth stock might have a P/E of 29.
Therefore, a simple and common way to categorize a group of stocks is to rank
them from high to low on a Price-to-X ratio, and then draw a line straight
through the middle of the list. Everything above the line (higher ratios) is
considered a growth stock, everything below the line is considered value.
This is a pretty crude, some might say simplistic, distinction. After all, if you
divide the S&P 500 into two groups as just described, is there that much
difference between the 249th and 250th stocks? Of course not. Yet the first will
be called a growth stock, the second a value stock.
Nevertheless, studies show consistently that value stocks (as a group)
outperform growth stocks over long time periods when all stocks are held for
long periods. For example, between 1983 and 2006, value stocks outperformed
growth stocks in 16 out of the 23 five-year holding periods that ended in those
years. From 1979 through 2006, the Russell 1000 Value Index returned 2.4%
more than the Russell 1000 Growth Index.
Why do value stocks produce higher long-run returns?
There are several reasons:
The first reason derives from the way the two categories are constructed. By
definition, if growth stocks include all stocks above the median Price-to-X ratio
for a given universe of stocks, the growth category will include practically all the
stocks that are overvalued—priced too high compared to where they are likely
to be priced in the future. Investors as a group have a tendency to overestimate
the growth potential—and the time-frame during which fast growth can be
sustained—and therefore tend to overvalue such stocks when they are “hot.”
Over time, the inexorable market forces of rationality and reversion to the mean
will bring these stocks, on average, closer to their true worth. Overvalued stocks
will see their prices reduced (or grow more slowly) in comparison to their value-
stock cousins.
The same principle works in favor of the value stocks. That group, by
definition, contains almost all the stocks that are undervalued. Market
participants as a group tend to underestimate the long-term growth potential of
slower-growing stocks, especially if they are living through a tough patch in their
businesses. So such stocks tend to be undervalued. The same market forces as
previously mentioned will tend to bring the prices of those stocks up relative to
the growth group.
The second reason is a camouflaged outcome of the long-holding-period ground
rule. None of the studies that I have seen consider what happens if an investor
utilizes sell-stops or some other selling discipline to curtail losses on his or her
holdings. Many sensible investors buy growth stocks because they are on a tear,
growing not only their revenues and earnings but also their stock prices. If there
were a law that any stock, once purchased, must be held for five years (the
holding period reflected in the study mentioned earlier), not many rational
investors would participate. It is unreasonable to expect a fast-growth stock to
outperform for five years running. So the rules of the studies are stacked against
growth stocks and in favor of value stocks.
A third reason is that the value group tends to harbor more dividend payers.
Several studies have shown that dividends—especially reinvested dividends—
account for up to half the total return of stocks over long periods of time. So
again, the growth stocks are at a long-term disadvantage compared to the value
stocks.
What are the lessons for the individual investor? To me, there are three:
• It is reasonable to have a “value tilt” to one’s stock holdings. That said,
remember that the value advantage tends to reveal itself over long holding
periods. If long holding periods do not suit your personality, be careful. You will
find it psychologically difficult (or impossible) to hold onto a declining or
“sideways” stock for a long time while you are waiting for the market to figure
out its true value—which may take years. It will feel like "dead money" to you.
Not only that, you may be wrong about the stock’s real potential. Just because a
stock is a value stock does not mean that its price is going to rise. It may have a
justifiably low valuation because it is a lousy stock. Which leads to lesson
number 2:
• Analyze your purchases before making them. Take a holistic approach.
Don’t buy any stock just because it is a value stock, pays a dividend, or for any
other single reason. Know why you are buying a stock before you buy it. Look
at it from multiple perspectives. The crude value-versus-growth categorization is
just a single factor, and perhaps not a very helpful one at that.
• Have an exit strategy. Whether you use sell stops or some other
discipline, you should know under what circumstances you will sell it. If a
growth stock does great for you for a year or two but then goes into reverse,
sell it, unless there are good reasons which you can articulate for holding onto it.
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