By: Frank Armstrong, CFP, AIF
Growth investors have had substandard returns when compared to investments in either the entire market, or value investors. Why should that be? Why should investing in healthy growing companies have lower returns than investing in distressed companies? The question has a lot of financial economists scratching their heads, and inspired some heated academic debate. While there is wide agreement that growth is an inferior investment style, that’s about all they agree on.
On one side we have a group of behavioral financial economists that believe that investors systematically overpay for growth stocks and underpay for value stocks. In other words, the market is not efficient, and investors are too dumb to realize it. Their view is that the growth value puzzle is a persistent anomaly. Taking that argument a step further, some day investors will all realize that they are paying too much for growth and the prices will fall to equalize returns.
Taken to its logical conclusion until that day happens there should be an arbitrage opportunity. (Arbitrage is the simultaneous selling and purchasing of miss-priced assets in order to realize a risk free profit.) Investors should be able to sell growth stocks short, use the proceeds to purchase value stocks, and make a risk free profit. In the process the opportunity for risk free return disappears as prices and returns are equalized in the marketplace.
That type of argument just won’t fly on the other side populated by efficient market advocates. They argue that there is no arbitrage opportunity because the return premium comes in spurts. While the value premium (the difference in returns between growth and value stocks) is large and persistent over time, it does not show up reliably each year. There will be extended periods of time when growth outperforms value. We don’t have to remember back very far to get that point. Value investors were severely disappointed during the 1990s.
The value gurus, headed up by Professors Gene Fama of the University of Chicago, and Ken French of Dartmouth, argue that there are three dimensions of risk in the equity markets. First is market risk itself. If investors want additional return over what the full market offers them, they can assume additional risk in two dimensions. They can either invest in smaller companies or value (distressed) companies. But, either carries its own risks. There is no assurance of additional reward during any particular time period. The premiums are there because of the additional risk.
Here is where the argument gets a little complicated: If there were additional risk in value stocks, we would expect it to be manifested by additional variation (standard deviation of returns). But, it doesn’t happen. The standard deviation of value portfolios is not much different than growth portfolios. But the average return is about five percent higher.
Fama-French still believes that the market is pricing in a risk factor, but contend that the factor is not captured by standard deviation. Their reasoning is that investors clearly prefer healthy companies to distressed ones, and that to compensate them for this additional risk they must expect higher returns. The only way that can happen in markets is to drive the price of value stocks down to the point where anybody willing to purchase them can expect a higher return than if they invested in healthy companies.
Another way to view the problem is to consider cost of capital to the company. Cost of capital for a company is the flip side of investor return. The two are equal. We would expect healthy companies to have a lower cost of capital whether they are borrowing from banks, issuing bonds, or issuing stocks. Distressed companies will have higher costs of capital. In the stock market that means that they will have to issue more stock to raise a dollar of capital than would a healthy company.
Clearly growth stocks are higher priced than the market as a whole or value stocks. We can measure that by P/E (price earnings ratio) or P/B (price book ratio). By comparison, value stocks are lower priced. In a world where every stock must be owned by somebody at the end of each business day, there is only way for the market to clear. Prices of less desirable (distressed or value) company stocks to fall to the point where they are attractive. So, Fama-French argue that the market is simply doing its job of rationing capital to firms and that the price mechanism is an efficient mechanism for that function.
As an investor, I really don’t care. I’m convinced that there is a value premium that is real, persistent, and non-trivial. I’m willing to endure periods of underperformance in order to capture that additional return over the long haul. So, I give my portfolio a strong value tilt and avoid a separate growth category asset class.