On average, value investing beats growth investing. To me, the evidence is overwhelming. Using Canadian data for the period 1986-2014, my research shows that value beat growth, on average, by about 11 per cent. Figures are comparable for the United States as well as Europe, Australasia and Far East (EAFE) markets.
Investors widely use the terms value stocks and growth stocks, but many don’t know what they mean. The above findings are from academic research, not value-investing practitioners. Academics sort stocks by price-to-earnings (P/E) or other metrics and form a number of portfolios from the sorted stocks. They call the lowest P/E group of stocks “value stocks” and the highest P/E group of stocks “growth stocks.” When commentators then say value beats growth, they mean the lowest P/E group of stocks returns, on average, more than the highest P/E group.
While the outperformance of value stocks, thus defined, has been known for years, academics have disagreed on the reason for such outperformance. One group of academics argues in favour of a risk-based explanation. Value stocks, they say, are exposed to higher risk than growth stocks and this drives their outperformance. Another group of academics argues that value and growth stocks are mispriced in the market. Investors, in particular, tend to overpay for growth. To date, most of the evidence sides with the mispricing argument.
Let me explain. The P/E ratio is a function of the growth rate of earnings going forward. This relationship can be found in a mathematical formula derived from the equity valuation model taught at every university. Companies have low P/Es because markets expect low earnings growth. Companies have high P/Es because markets expect high earnings growth. However, the way the growth rate comes into the mathematical formula implies growth forever. That is, a high P/E firm is forecast to sustain a high growth rate and a low P/E firm a low growth – in both cases, forever. The markets tend to be overly optimistic about growth for high P/E firms and overly pessimistic about growth for low P/E firms. As a result, investors bid up (overvalue) high P/E firms and bid down low P/E firms.
As investors are overoptimistic about growth stocks, on average, they tend to be disappointed in a down market and not so surprised in an up market, and as they are overpessimistic about value stocks they tend to be pleasantly surprised in an up market and not so surprised in a down market. This leads to the outperformance of value stocks.
In a recent study I conducted, I provide further evidence of mispricing. I find that the key reason that growth stocks underperform is that many of the high P/E stocks tend to migrate to a lower P/E group over time – much more frequently than the value stocks migrating to a higher P/E group of stocks. Growth investors seem always to have high expectations for growth stocks. They tend to underestimate the probability that the P/Es of these stocks will decline and are subsequently disappointed.
How about the performance of growth stocks that do not migrate to a lower P/E group? To answer this question, I compared the value stocks in my sample to growth stocks that do not change P/E group. I find that value stocks in this case, on average, underperform growth stocks by 5.4 per cent over the study period (1986-2014).
In other words, if an investor had the ability to determine which growth stocks were not going to move to a lower P/E group and invested in these stocks, then this investor would tend to have a stellar long run performance. Unfortunately, this is not easy to do. That is why, it is best to avoid growth stocks altogether and concentrate on value stocks by following the value investing process, namely, start with low P/E stocks, value them to determine their intrinsic value and make a decision to invest only when the desired margin of safety is met.
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