Value beats growth: the evidence

In a research paper for institutional investors published today, James Montier a proponent of behavioural investing at Soc Gen, demonstrates that value stocks not only return more than growth stocks, they’re also less risky.

That’s good news for value investors, and bad news for those who cling on to conventional finance theory, which says to beat the stockmarket, you must take on more risk.

Mr Montier uses finance theory against itself deploying standard deviation and beta, traditional measures of risk widely used in academia and the City, to compare value and growth stocks*^1.

Generally speaking standard deviation and beta measure volatility. The more a company’s share price swings about, the more risky it’s deemed to be.

1. Standard deviation

(the higher the standard deviation, the more variable the sequence of prices and the ‘riskier’ the company).

2. Beta

(the higher the beta, the more variable the share price in comparison to the market and the ‘riskier’ the company)

In both charts, growth stocks are more risky.

There’s semi-good news for value investors, even in times of uncertainty, like now. While value stocks decline in the worst months for the stockmarket, growth stocks decline more. When the probability of recession is relatively high, the ‘value premium’ (the higher return from value stocks) is diminished, but it’s still about 8% per annum, versus about 10% during times of expansion.

Mr Montier concludes:

Much as fans of the EMH would love us all to believe that value tends to outperform because it is riskier, there is virtually no evidence that this is actually the case. Over a wide range of measures value appears to be no riskier (and often less risky) than growth. The risk-based explanations of the value premium are as hollow and meaningless as the rest of EMH.

EMH being the Efficient Market Hypothesis, a theory that I’ve taken issue with before, albeit in a slightly less scholarly fashion!

The subject of my last post (Screwed up markets are best), Warren Buffett, is also a heretic. In a recent interview with Forbes he gave a practical account of the inefficiency of markets:

It may have some meaning to you if you’re still being taught efficient-market theory, which was standard procedure 25 years ago. But we’ve had a recent illustration of why the theory is misguided. In the past seven or eight or nine weeks, Berkshire has built up a position in auction-rate securities [bonds whose interest rates are periodically reset at auction...] of about $4 billion. And what we have seen there is really quite phenomenal. Every day we get bid lists. The fascinating thing is that on these bid lists, frequently the same credit will appear more than once.

Here’s one from yesterday. We bid on this particular issue – this happens to be Citizens Insurance, which is a creature of the state of Florida. It was set up to take care of hurricane insurance, and it’s backed by premium taxes, and if they have a big hurricane and the fund becomes inadequate, they raise the premium taxes. There’s nothing wrong with the credit. So we bid on three different Citizens securities that day. We got one bid at an 11.33% interest rate. One that we didn’t buy went for 9.87%, and one went for 6.0%. It’s the same bond, the same time, the same dealer. And a big issue. This is not some little anomaly, as they like to say in academic circles every time they find something that disagrees with their theory.

So wild things happen in the markets. And the markets have not gotten more rational over the years. They’ve become more followed. But when people panic, when fear takes over, or when greed takes over, people react just as irrationally as they have in the past.

As Mr Montier and Warren Buffet note, wild things happen because of sentiment, that’s something conventional financial theory has yet to fathom fully.

Footnotes:

1. Mr Montier measured portfolios based on the ratio of cashflow to price. The cheapest 20% of shares he defined as ‘value’, and the most expensive 20% he defined as growth.