With Canadian and U.S. markets hitting their highest levels in 18 months, it's important to keep a close eye on the returns of value stocks versus growth stocks.
My research is leading me to believe that the only time growth beats value is as the economy heats up and people start to believe that "this time things will be different." This causes them to overestimate growth and they end up paying too much for it. But it's never different.
When growth beats value, it's time to worry about a correction.
On average, value investing beats growth investing. The evidence is overwhelming. My research shows that from 1985 to 2006, value beat growth, on average, by 6 per cent in Canada. In the U.S., value beat growth by 6 per cent on the New York and the American (AMEX) stock exchanges, and 12 per cent on the Nasdaq. Other research shows this result in European, Australian and Southeast Asian (EAFE) markets as well, with value beating growth by 13 per cent.
Moreover, value wins in bear and bull markets, in recessions and recoveries; value portfolios have lower betas and standard deviations than growth portfolios; value performs better when news is bad and when news is good.
More on value investing:
Investors widely use the terms value stocks and growth stocks, but many don't know what they mean. The statistics above are from academics, not value investing practitioners. And academics don't know what stocks value investors actually buy.
Academics sort stocks by price-earnings multiples (P/E) or other metrics, and form a number of portfolios from the sorted stocks. They call the lowest P/E stocks "value stocks" and the highest P/E stocks "growth stocks." Even though academics don't know which stocks from this group value investors will buy, they know that value investors mostly choose stocks from the lowest P/E group and avoid stocks from the highest P/E group.
When commentators say value beats growth, they mean the lowest P/E group of stocks return, on average, more than the highest P/E group. Because of this, many investors believe that the only thing value investors do is sort stocks by P/E and invest in the lowest P/E stocks.
But this is just the first step in the value investing process. Next, investors value each of the low P/E stocks individually to determine which ones are truly undervalued. A stock may have a low P/E because it is a bad stock. The only way to differentiate the good from the bad is to value all stocks in the low P/E group.
The final step in the value investing process compares the intrinsic value of each stock to the market price. If the stock price is lower than the intrinsic value by more than what's known as the "margin of safety" (normally 33 per cent of the intrinsic value), the stock is considered truly undervalued and it's worth investing in.
If value beats growth at the naive step of screening stocks for low P/E, imagine how much better the truly undervalued stocks perform. My research is the first to examine all steps in the value investing decision process. It shows, on average, that the three-step value investing process beat investing in the low P/E stocks by 1.1 per cent from 1985 to 1998, by 13.2 per cent from 1999 to 2006, and 15 per cent for 2007 and 2008.
I'm often asked, if the evidence in favour of value investing is so overwhelming, why isn't everyone a value investor? Why does a value premium still exist? Shouldn't it be eliminated? Not necessarily, because the driving forces behind the value premium are human psychology and institutional biases.
People aren't rational, and individuals working for institutions don't always have the best interests of clients at heart. Individuals, not institutions, make investment decisions; individuals have their own psychologies, over which they have little control, and their own agendas, which may differ from the agendas of their organizations.
People extrapolate past performance; they are overoptimistic and overconfident; they overreact and herd. Those who are managing money for institutions herd to protect their jobs, rebalance portfolios to make their year-end bonuses, and window-dress to spruce up the portfolios that appear in the annual reports they send to investors. The interaction of these forces biases stock prices in a way that gives rise to value investing opportunities.
These two causes don't look like they'll change, so value investing opportunities will continue to exist.
But value doesn't beat growth all the time, just most of the time. As the economy heats up in the upswing of the business cycle, people overestimate growth and overpay. When growth beats value, it's time to consider getting out of the market.
Value Investors Add Value
Return by which the value investor portfolio (Q1S) beat a low P/E portfolio (Q1) between 1985 and 2008
Value Investor Premium
Q1S - Q1