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Sunday 15 March 2009

Clairvoyant Value

51 Years of Value Beating Growth

It’s a kind of truism in the markets that value stocks outperform growth stocks. However, it’s pretty hard to get demonstrable evidence of this. Arnott, Li and Sherrerd (2008) have come up with an interesting take on the problem. Instead of projecting forward they’ve gone back in time and looked at how companies performed in comparison to their historic earnings multiples.

By looking at this so-called clairvoyant value – analysing in hindsight – they’ve been able to show that the suspicion is correct and value stocks do outperform in terms of actual returns. However they’ve also shown that the market is generally pretty accurate in identifying growth companies – it’s just lousy at valuing them correctly.

Overpaying for Growth Stocks

The essence of the research is to travel back in time fifty years and then measure how well a stock has performed over time. As we know the actual performance we can then analyse whether the original market predictions for the stock were any good or not. There will be, no doubt, plenty of arguments about the assumptions that underpin the research. Clairvoyant Value in the paper is adjusted for survivorship, which is good, and assumes dividends leave the portfolio, which is less good although is probably realistic.

Anyway the key findings are that the market is pretty good at identifying which companies will grow fastest. Unfortunately it then goes onto assign values to such stocks that are too high, indicating that people overpay doubly for growth stocks compared to value stocks.

The result is that investors in value stocks get better returns than investors in growth stocks, despite the latter’s earnings outperforming the former. It also suggests, strongly, that small capitalisation value stocks hugely outperform large capitalisation growth stocks. Into the bargain it also stuffs up the Efficient Market Hypothesis as a long term theory as well as a short-term one.

Value Wins in the Long Term

These results appear to hold over all time periods since 1956. To quote the paper:
Perfect foresight through 2007, which implies 51 years of clairvoyance for our earliest data, provides an even more powerful result: the market never failed to overpay for the long-term realized successes of the growth companies, even though the market chose which companies deserved the premium multiples with remarkable accuracy.
All of which suggests that fundamental indexing based on value principles or value investing based on discounts to NTAV or intrinsic value ought to underpin most investors’ approaches.

Always nice to have some confirmation.

Arnott, Robert D., Li, Feifei and Sherrerd, Katrina F.,Clairvoyant Value and the Value Effect(September 3, 2008). Available at SSRN:

Related Posts: Arnott: 40 Years of Bonds Beating Equities, Don't Overpay For Growth

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