By Michael Nairne, Tacita Capital
For many investors, beating the market is the holy grail of investing. In fact, google the phrase "beating the market" and you get 14 million hits, more than seven times "passive investing". Yet, beating the market over the long-term is extremely difficult. By definition, the market includes all stock owners and hence, investors as a group earn the market return – for every winner there must be a loser. In confirmation, a litany of studies has found that fund managers in aggregate achieve market-like returns less fees and costs.
However, the potential to beat the market does exist. Over the past several decades, the painstaking examination of historic stock performance in numerous countries has pointed the way to outpacing the market. The findings indicate that value stocks - those low-priced in relation to earnings, dividends and book value - have higher expected returns than growth stocks - those high-priced in relation to earnings, dividends and book value. Over the long-run, value investors are the winners; they earn a premium to growth investors who are the losers.
This premium is evidenced in the following graph which illustrates the growth of $1.00 U.S. invested in large value stocks (in red) compared to large growth stocks (in green)
and to the S&P 500 (in blue) from August 1927 to May 2009. The investment in value stocks grew to $4,454 - more than four times the $868 of the growth stocks and nearly three times the $1,578 of the S&P 500 which, although growth-tilted, contains both value and growth stocks.
The historic outperformance of value stocks is not restricted to the U.S. market. In a study on the United Kingdom stock market from 1900-2000, Dimson, Marsh and Staunton (DMS) found that value stocks achieved an annual return of 11.5 percent, a 2.9 percent premium to the 8.6 percent return of growth stocks and a 1.4 percent premium to the market overall. They conclude that "over the long term, the historical record of value investing has been positive ... we now know that value stocks did better than growth stocks in the earlier as well as later parts of the twentieth century."
In fact, in a sweeping review of the research on the value premium in international markets, DMS found that value stocks outperformed growth stocks in thirteen out of fourteen countries including Canada. Italy was the only exception. The value premium is therefore a global phenomenon.
But this begs the question … why? Without a meaningful explanation, it is possible (although not probable given the length and breadth of its occurrence) that the value premium is a statistical fluke or worse, an historic anomaly now widely known, avidly pursued by knowledgeable investors and hence as prices are bid up, no longer available to future investors.
Economic theory offers us two explanations for the value premium. First, behavioural finance experts argue that cognitive biases hardwired into the human psyche often lead to the systematic mispricing of value stocks. David Dreman, a leading apostle of this view, believes that investors routinely overreact to recent news concerning a given stock. If it is good news, they tend to project a continuance of this favourable trend and bid up the price of the stock. When bad news confronts investors, an opposite reaction is triggered. Believing a negative trend to be firmly in place, investors either hold or sell and the stock price subsequently languishes. Yet, inevitably, some negative event occurs to cause the higher-priced growth stocks to tumble while conversely, enough positive surprises occur to send the value stocks spiralling upwards.
Investors appear to naively extrapolate recent earnings trends and only adjust their expectations slowly as recurrent surprises occur. One study by Fuller, Huberts and Levinson
found that while high-priced glamour stocks initially have much stronger earnings growth rates than low-priced value stocks, after five years or so this difference becomes negligible. As the market slowly adopts scaled-down earnings expectations as the new norm, value stocks enjoy superior returns as their price moves up at a relatively faster pace than that of the slackening growth stocks.
Another behavioral view holds that investors often confuse the characteristics of a good company (e.g. powerful brand, positive image, superior growth) with the elements of a good stock (i.e. a price that is low in relation to discounted future cash flows). One study found that the stocks of companies considered "excellent" according to the standards outlined in the best-seller In Search of Excellence materially underperformed the stocks of "unexcellent" companies!
The second explanation for the value premium comes from the efficient market school of thought. Under the efficient market hypothesis, the prices of stocks reflect all available information and hence, higher expected returns must rationally reflect higher risk. Originally, efficient market supporters did not believe there was sufficient evidence of a value premium. Then, in a 1992 landmark study covering the period 1963-1990, Professors Eugene Fama and Ken French found that value stocks outperformed growth stocks by a statistically significant margin. In 2000, a second study covering 1929-1963 contributed strong out-of-sample confirmation of the existence of a value premium.
According to Fama & French, however, value stocks are generally shares of companies that are in comparatively worse financial shape than companies whose shares are growth stocks. Investors demand a higher return for their investment in value stocks because of the greater risk the company will deteriorate financially or even go bankrupt. This is no different from bankers or bondholders who charge a higher rate of interest to companies in poor financial shape. The poor performance of value stocks during the Great Depression may be indicative of this risk.
Both the behavioral and efficient market explanations for the value premium are compelling. In academia, a vociferous debate exists as to which is the foremost cause of the value premium. From an investor's perspective, however, the critical aspect of both explanations is that each supports an enduring value premium that is unlikely to disappear. However, the exploitation of the value premium rests on one key characteristic – patience - since the premium is highly volatile and can disappear or even go negative for years.
This volatility is evidenced in the following graph which depicts the 36-month rolling average annual return of the Fama-French Large Value Premium (i.e. the return of large value stocks minus large growth stocks) for the U.S. market for the period August 1929 to May 2009. Although value stocks outperformed growth stocks by an average annualized 3.24 percent, there are intermittent periods where growth stocks outperformed, sometimes by a significant margin, and some of these periods can persist for a number of years, such as occurred through much of the 1930's and 1990's.
To the thoughtful investor, the volatility of the value premium is reassuring. A premium which showed up with any regularity would disappear almost immediately since it would be arbitraged away by traders. Instead, the value premium is available to patient, long-term investors who are interested in beating the market. Impatient investors will need to look elsewhere.
July 23, 2009
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