Over the past 15 years, various studies have been carried out that point to value stocks as returning higher annualized gains than growth stocks by as much as 7.6%. Who did the research, and what did they discover?
Value Stocks Outperforming Growth
Two high-profile studies compared investing strategies over a similar time frame from the mid-70s to the mid-90s. The first group, informally known as Fama and French, studied value stocks versus growth stocks. How Eugene F. Fama and Kenneth R. French define a value stock in their 1997 paper titled, Value Versus Growth: The International Evidence?
- Low price to book ratio
- Low price to earnings ratio
- Low price to cash flow
- Low price to dividend
Note: If you reverse the equation, book to price ratio for instance, then higher is better for selecting value stocks.
The group found that value stocks outperform glamor or high-growth stocks an average of 7.6% per year. Another researcher by the name Joseph Piotroski reached similar conclusions with his piece written in 2000 titled, Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers. He was able to theoretically achieve over 23% annualized gains with his value portfolios.
Does this mean that we should avoid growth stocks? No, and here are some reasons why.
Keep in mind that we are talking about massive groups of averages with little qualitative analysis. Based on numerical stock screens, you can separate stocks into growth or value. The studies looked at broad averages. But many growth stocks are able to achieve extremely abnormal returns, such as Apple growing from $7 in 2003 up to over $350 today.
If you are a very diligent investor with the ability to see potential in small companies, then high-growth investing could return some big winners. On the other hand, many small companies struggle with financing or are crushed by the leading company giants. De-listing companies that go bankrupt will vastly lower high-growth portfolio averages.
If you trade averages, value investing has been proven to return larger annualized gains. If you have a knack for picking winners amongst a group of potentials, high-growth stocks still have much shine. But there is another aspect to consider between value and growth.
The Link Between Stocks and Market Cycles
In 2003, Yul W. Lee and Zhiyi Song wrote a paper that showed the correlation between value and growth stocks and the market cycles. What did they discover in the paper titled, When do Value Stocks Outperform Growth Stocks? Investor Sentiment and Equity Style Rotation Strategies? First, we need to understand a simple concept of the put-call ratio.
The put-call ratio compares the amount of put options contracts being sold in the market to call options contracts. Put options increase in value when the market drops, and call options increase in value when the market climbs. You can quickly determine investor sentiment by looking to the put-call ratio.
- If the ratio is high, investor sentiment is bearish.
- If the ratio is low, investor sentiment is bullish.
The research paper suggested that when investor sentiment is bullish, as shown by a low put-call ratio, growth stocks tend to outperform value stocks. Perhaps this is because growth stocks are viewed as having a higher upside, so traders flock to them when the pastures look green. In virtually every other market though, value stocks appear to outperform.
Value and Growth Investing: A Definite Winner?
I would call this debate far from over. Value wins out overall, especially when looking at broad averages. Growth wins out in certain markets. Still, with the large amount of abnormal returns in high growth investing, if researchers were able to find the winning metrics of these rocket stocks, the tables would turn once again. At this point, the argument is slanted in favor of value with high growth looking for its next footing in the battle.