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 simple and common way to categorize a group of stocks is to rank them from high to low on a Price-to-X ratio basis, 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 250th and 251st 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 when stocks are held for long periods. For example, between 1983 and 2006, value stocks outperformed growth stocks in 16 out of the 24 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. (Each index is reconstituted annually.)
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 in that universe that are overvalued—priced too high compared to what they are really worth. Investors as a group have a tendency--when analyzing fast-growing stocks--to overestimate both the rate of growth and the timeframe during which fast growth can be sustained. They therefore tend to overvalue such stocks. 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 growth potential of slower-growing stocks, some of which may just be living through a tough patch in their business and so are 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 consider what happens if an investor utilizes sell-stops or some other selling discipline to lock in gains or 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--but not necessarily at a short-term disadvantage.
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 “dead money” stock for a long time while you are waiting for the market to figure out its true value—which may take years. Not only that, you may be wrong about the stock’s 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 every stock you own. 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. Don't feel that you have to be in the buy-and-hold school to be a good investor.
Dave Van Knapp is the author of Sensible Stock Investing: How to Pick, Value, and Manage Stocks. If you would like to learn about a stock investment approach that uses the same strategies reflected in this article, please click on this link to go directly to the book's page on Amazon.com: http://www.amazon.com . Or click on this link to learn more about the book and its sytematic approach to investing: http://www.SensibleStocks.com . Thank you.
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