5  Value stock out-performance

Value investing is a investment approach that involves buying stocks that appear under-priced based on some form of fundamental analysis. This is the bedrock of Warren Buffet’s approach to investing.

Typically, that fundamental measure is based on an accounting measure such as earnings, cash flow or book value, rather than future growth. Value stocks are those stocks which have low prices relative to those accounting measures. Growth stocks are stocks with prices high relative to those measures as people anticipate high future growth.

There are many examinations of the performance of value stocks versus growth stocks. Fama and French (1992) grouped all stocks traded on the New York Stock Exchange, AMEX and NASDAQ into deciles based on their book-to-market ratio. Those in the highest book-to-market ratio decile, the value stocks, had an average return 1.5% per month higher than those in the lowest decile, the growth stocks.

5.1 A behavioural explanation

One possible reason for value stock out-performance suggested by Lakonishok et al. (1994) is that investors are making an error in the expectations of future growth as their expectations are excessively tied to past growth. They believe stocks with high growth in price now will have high growth in the future, despite the fact that future growth rates are highly mean-reverting (that is, stocks with high growth rates today tend to have more typical growth rates in the future).

Conversely, Fama and French (1992) simply argued that value stocks are riskier. (Recall the joint hypothesis problem.)

Fama, E. F., and French, K. R. (1992). The cross-section of expected stock returns. The Journal of Finance, 47(2), 427–465. https://doi.org/10.1111/j.1540-6261.1992.tb04398.x

Lakonishok, J., Shleifer, A., and Vishny, R. W. (1994). Contrarian investment, extrapolation, and risk. The Journal of Finance, 49(5), 1541–1578. https://doi.org/10.1111/j.1540-6261.1994.tb04772.x