Some people believe in Santa Claus. Others believe in the Tooth Fairy. Many investors believe value stocks will outrun growth issues and be a lot less volatile along the way.
Is the value advantage a myth that belongs in the land of St. Nick? Those investing during the growth-driven 1990s would say yes. Academics and value-fund managers, on the other hand, would say no. Who's right?
This lesson will examine both sides of the debate, and explain what this means for your portfolio.
The Value Investing Supporter’s Say
Let's start with value investing's most famous supporter, Benjamin Graham. Graham looked for stocks selling at discounts to their net current assets. Specifically, Graham bought stocks priced at 66% or less of their company's underlying current assets. Over a 30-year period through the mid-1950s, a portfolio of such stocks gained a hearty 20% per year, on average.
Graham also coined the term "margin of safety" in the 1934 book Security Analysis, which he co-wrote with David Dodd. And Graham's disciples have championed the idea ever since. Graham argued that by buying stocks below what they're worth, you can cut your losses with minimal harm if the company doesn't rebound.
In subsequent years, countless academic studies proved that Graham was on to something. Most of the studies focused exclusively on the returns of value stocks, not on their risk characteristics.
In 1986, for example, Harry Oppenheimer studied the returns of stocks listed on the NYSE and AMEX trading at 66% or less of their net current assets between 1970 and 1983. The mean return from net current asset stocks during the period was 29.4% per year versus 11.5% per year for the combined indices. That same year, Roger Ibbotson studied stocks that were trading at low price/book and price/earnings ratios between 1967 and 1984 and found that stocks with low price multiples had significantly better returns over the period than stocks with high price multiples.
Studies that proved value investing's superiority continued to appear throughout the early 1990s. Eugene Fama and Kenneth French studied nearly 30 years' worth of monthly stock returns between 1963 and 1992. They showed that low price/book stocks outperformed high price/book stocks by, on average, 4.9% per year. (Note: Fama and French's findings sliced stocks according to size, too. They concluded that small-value stocks, in particular, offered the greatest performance edge.)
Risk finally returned to the discussion in 1993. Josef Lakonishok, Robert Vishny, and Andrei Schleifer examined the investment returns of all NYSE- and AMEX-listed companies relative to their price/book, price/earnings, price/cash flow ratios between 1968 and 1990. The trio found that value strategies not only offered higher returns, but they concluded that value stocks were less risky, too: Value stocks generally outperformed growth stocks during the market's worst months.
What Detractors Say
Despite what seems like overwhelming evidence in favour of value investing, this strategy faced challenges in the late 1990s. Value stocks bobbed behind growth stocks in the late 1990s: Large-growth funds gained 18.1% per year, on average, between 1996 and 2000 while large-value funds rose just 13.9% per year. That significant underperformance brought out the critics. And the critics raise some tough-to-refute points.
Most notably, detractors point out that none of these value studies include the costs of buying and selling stocks. While assuming a cost-free world is useful for spotting patterns, it's not a luxury accorded to real-world investors and fund managers. Making matters worse, the studies involve rebalancing portfolios annually, or selling all the portfolio's holdings and buying a whole new set of holdings. In the real world, the cost of such turnover could snatch away much of the return. The transaction-costs issue suggests most investors can't completely match the results of such studies.
Detractors also question the idea that value stocks are inherently less risky than growth stocks--in other words, they don't buy the "margin of safety" concept. Although a collection of value stocks together may offer some margin of safety, that margin can quickly evaporate for individual stocks whose underlying businesses face some fundamental risk.
Philip Morris is proof of that. The stock entered 1999 trading with a price/earnings ratio in the low 20s, below that of the S&P 500. Value-fund managers argued that the stock was trading well below the value of its subsidiaries, Kraft Foods and Miller Brewing. By Graham's definition, the stock seemed to have a margin of safety. How much further could its price fall?
Evidently, quite a bit further. Continued tobacco litigation cut Philip Morris' share price in half in 1999. The stock's P/E withered to a sickly 7.2 by year's end. The lessons: Cheap stocks can always get cheaper, and a cheap stock isn't always a bargain.
Moreover, the dividend's demise is, theoretically at least, making value stocks, as a group, more risky than they've been before. Dividends used to cushion returns of many value stocks during falling markets. That's because even as shareholders were losing money as the company's stock price slid, they were at least receiving some return in the form of dividends. As dividends diminish, value stocks may lose their resiliency.
Finally, value stocks have been less reliable than growth stocks in some down markets, such as 1990's recession. That year, the average large-value fund lost 6.4% while the average large-growth fund lost just 2.4%. That's because many value stocks are cyclical--in other words, they're sensitive to economic cycles. They flounder during recessions. Many growth stocks, however, thrive (relatively speaking, of course) during recessions, especially stable companies in the food, beverage, and pharmaceutical industries. No matter how tough times get, we all need to eat and take our medicine.
What This Means for Your Portfolio
So should you even bother with value stocks? Yes--but not because you expect some sort of performance edge from them. Rather, own value stocks for diversification purposes.
Growth and value styles tend to perform well at different times. Even during the growth-driven 1990s, for example, value stocks had their days. In 1992 and 1993 and again in 1997 and 1998, roaring financial stocks (the stomping grounds of many value funds) drove value funds ahead of growth funds.
Investors whose portfolios included value and growth stocks remained competitive throughout the 1990s. Those whose portfolios featured only value stocks or only contained growth performed in fits and starts.
An individual value stock may not be less risky than an individual growth stock. Nor will a portfolio of value stocks always lose less in a down market than a portfolio of growth stocks. But it's pretty likely that, over the long term, a portfolio that includes both types of stocks will be less risky than one that owns only growth or only value.
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