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Thursday 2 July 2009

Don’t Overpay For Growth

Why’s Value Better?

A moment’s serious thought should tell us that investing in growth stocks ought to be a better stockmarket strategy than any other. Growth stocks, by their very nature, grow their earnings faster than other stocks so – obviously – they ought to be better investments. But investing’s not a zero sum game and the obvious often isn’t what it appears to be.

Investing in growth stocks all too often turns out to be a less than optimal stock allocation strategy but the simplistic argument that companies on lower ratings perform better than companies on higher ones simply won’t do. Value type companies are on lower ratings because their ability to grow their earnings is lower. All things being equal this shouldn't translate into better share price performance. It does – so what’s going on?

Bubbling Growth

One simple answer, frequently given, is that growth stocks are the stuff of bubbles. There’s never been a bubble in lowly rated, moth-eaten, downtrodden, ex-growth value companies and, offering a rare prediction, I don’t think there ever will be. So when bubbles pop it’ll be the exciting growth pedigree stories that are bursting, not the mangy mutts that no one wants to re-home.

Recent research by the Brandes Institute confirms the long standing evidence of the superior performance of value over growth. Value vs. Glamour: A Global Phenomenon extends existing US based research across the globe to come to the following conclusions:
"Between 1968 and 2008, we found U.S. large-cap value stocks ... outperformed U.S. large-cap glamour stocks ... by 6.8% on an average annualized basis across 5-year periods. In the small-cap arena, U.S. value stocks returned an average annualized 9.7% more than their glamour counterparts across 5-year periods.

In non-U.S. developed markets, the premium for large-cap value stocks was 8.6% greater than large-cap glamour stocks between 1980 and 2008. Again, returns were annualized on 5-year periods. The difference was even greater for non-US small-cap stocks, where value stocks outperformed glamour stocks by 9.0% annualized. Note that this was not the absolute return for non-U.S. small-cap value stocks – this was the excess return over the small-cap value stocks."
To paraphrase: everywhere and at all times growth stocks suck.

Clairvoyant Investing

Although the Brandes research brings up to date and confirms what we already knew it doesn’t offer any explanation for why this is so. It’s like Newton’s Laws of Gravity – providing laws that are always applicable without offering the slightest explanation of why this should be so. Many of Newton’s contemporaries regarded the concept of invisible forces acting at a distance as magic, not science. For humans it’s not enough to accept that something is so, we need to understand why it is so. So why do value stocks outperform?

Let’s face it – all the great companies of the world today were once growth stocks, they didn’t get to be big by being low-growth, grungy value mongrels. There’s something counterintuitively weird going on. As usual it’s nothing to do with the intrinsic merits of the companies and everything to do with the warped sense of values in the heads of the people who invest in them.

As previously reported here, recent research by Research Affiliates has come up with an interesting new way of examining past performance of various types of stocks. The so-called Clairvoyant Value analysis goes back to 1956 and assesses future performance of stocks against whether they were then rated as value or growth through a combination of various valuation ratios – price-to-sales ratio, price-to-earnings ratio and price-to-dividend ratio – all relative to the market at the time. These are fairly typical investment ratios, low values of which are often used to define value stocks, high ones to weed out growth.

Given the Brandes research we should be pretty confident in predicting that the research shows that value stocks will outperform growth stocks and we wouldn’t be disappointed. They do, significantly. However, what is interesting and different about this study is that it gives us a window why this is so, rather than simply reaffirming the facts.

Growth Stocks Are Best, But ...

The first, notable point is that it turns out that our intuition about growth stocks being superior companies is, by and large, right on the money. Higher rated stocks justify their ratings by growing earnings significantly more than lower rated stocks. Investors correctly identify the growth stocks which will provide superior performance yet lower rated value stocks turn out to be better investments. What’s going on?

The simple answer is that we get excited about growth stories and overpay for them. Generally by about double what it turned out they were worth when we look at the discounted future cashflows of the companies at the various valuation points. The premium paid for growth stocks over value stocks has varied significantly over the period from a multiple of 1.6 times in 1977 – as the Nifty Fifty bubble burst – to 3.3 times in 1999 as dotcom mania exploded. Rarely has the premium turned out to be justified in terms of future, clairvoyant, growth. Here's what Research Affiliates had to say about this:
"Perfect foresight through 2007 provides an even more powerful result—for spans of 20 or more years, 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."
It’s perfectly obvious that it’s not anything about the intrinsic nature of the stocks that’s causing these effects, it’s human psychology in its purest form. Even when the markets are on their uppers, blood running in the streets, we still manage to push our money into the wrong stocks, incorrectly assuming that a good growth story equals a good investment. Unfortunately the opposite seems to be the truth of it and that’s highly unfortunate for us because we generally operate on stories and not numbers.

And It’s Getting Worse

The research also indicates that the premium that we’re prepared to pay for growth over value is actually increasing, contrary to any expectations about our ability to learn from our mistakes. This increase in “Value Dispersion” could be explained by a number of factors but most likely it means that investors are increasingly overconfident in their abilities to project forward future growth rates, despite all the evidence to the contrary.

One other factor that needs to be considered and doesn’t seem to be is the effect of survivorship on the statistics. You might suspect that higher risk growth stocks would be more likely to go bust than value stocks which ought to offer a margin of safety, but the studies don’t address this point. Intuition tends not to be a good guide to these things, but if it’s correct then growth stocks are even less attractive than they appear.

In general it’s interesting that it’s not our intuitions that let us down when it comes to growth stocks, it’s our number crunching. As ever, price is what you pay, value’s what you get. Invest with the head and not with the heart.

Related Posts: Clairvoyant Value, Overconfidence and Over Optimism, Fairy Tales for Investors

1 comment:

  1. It is a great theory, and I believe it. But I am not sure how we can apply it in real life portfolio management.