Tipping the Scale – Why Value Stocks Outweigh Growth Stocks

With the immense amount of information available to the investment world, finding one sure-fire means to invest is impossible. Theories and strategies abound, and everyone can pitch their 2 cents to make $10,000 fast, but a narrowed focus can trims options while providing a more concentrated and controlled environment from which to choose a strategy. One such strategy is value over growth, with particular emphasis on the small-cap segment.

Historical evidence supports the theory that value stocks, stocks trading at low price-to-book (P/B) ratios or low price-to-earnings (P/E) ratios, yield higher returns than growth stocks. A lower P/B ratio could signal that the stock is undervalued or that there are fundamental issues with the company. However, studies performed to test the advantages of buying value stocks vs. growth stocks demonstrate that over an extended period of time, value trumps growth.

In the mid-1980s, Roger Ibbotson conducted a now well-known study in which he sorted all the stocks on the NYSE into deciles based on P/B ratios from 1967-1984. At the end of each calendar year, these stocks were shuffled into their respective deciles based on year-end P/B value. The results show that the three deciles with the lowest P/B ratios generated a compound annual return of more than 14 percent while the three deciles with the highest P/B ratios generated a compound annual return of less than 6 percent.

The thesis that value outperforms growth and other strategies has been tested numerous times, with each test supporting the theory. One reason the growth strategy disappoints is that investors tend to overemphasize future growth, anticipating that strong current growth trends will continue well into the future. Those investors look at current/recent data and anticipate that the growth pattern will keep pace indefinitely, and willingly bid up high multiples of earnings and book value.

On the other hand, some investors will pay for expected future growth in sales and earnings even if that growth isn’t demonstrative at the time. Take the tech bubble of the late 1990s, for example. As the bubble swelled and new technologies and products emerged, investors in anticipation of potential growth bid emerging companies to high multiples of earnings (if in fact the company had any) or book value. When the bubble burst, it was a painful sign that much of the growth that was expected would never come.

A study measuring the performance of three recognizable small-cap company indices provides further support of the value philosophy, specifically in the small-cap market. The Russell 2000 Index is a measurement of the performance of the small-cap segment of the U.S. equity market. The Russell 2000 Growth Index measures the performance of the small-cap growth segment, including Russell 2000 Index companies with higher price-to-value ratios and higher forecasted growth values. The Russell 2000 Value Index measures the performance of small-cap value segment, including Russell 2000 Index companies with lower P/B ratios and lower forecasted growth values.

In the years between 1978 through December 2011, the Russell 2000 generated cumulative return of 3,254.0%. The Russell 2000 Value yielded 5,592.2% while the Russell 2000 Growth yielded 1,636.1%.
On an average annual return basis, the Russell 2000 generated 11.2%. The Russell 2000 Value generated 13.0%, outperforming the Russell 2000 Growth at 9.0% (Royce & Associates).

When it comes to investing, it is important to seek the stocks with the best value, and sometimes that means looking ahead vs. flipping a quick penny. Value investors look at stocks trading below their book value and their potential for deep value, and often time find these stocks in the small-cap market where high-potential stocks are undervalued. As Warren Buffett put it, the key to successful investment approach is not scrambling for a bargain, but rather “finding an outstanding company at a sensible price.”

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