NEW YORK - Value stocks outperform growth stocks over time because investors are excessively optimistic about the future prospects of "glamour" stocks, and excessively pessimistic about value stocks.
This is the conclusion of a study by Professors Josef Lakonishok of the University of Illinois, Andrei Shleifer of Harvard University and Robert W. Vishny of the University of Chicago.
Discussing the results of the study at the Pensions & Investments Investment Management Conference, Mr. Lakonishok said a number of studies had shown that value strategies outperform the market, but there was no agreement on why.
One explanation, he said, is that some investors tend to get overly excited about stocks that have done well in the past and buy them up so that these "glamour" stocks become overpriced. "Similarly," he said, investors "overreact to stocks that have done badly, oversell them, and the out-of-favor 'value' stocks become underpriced."
An alternative explanation, he said, was that investors in value stocks, such as high-book-to-market stocks, bear higher fundamental risk of some sort, "and their higher average returns are simply compensation for this risk."
Mr. Lakonishok and his colleagues examined a range of value strategies and found they produced higher returns. They then examined whether or not value stocks were fundamentally riskier than glamour stocks. "We find little if any support for the view that value strategies have been fundamentally riskier," he said.
Mr. Lakonishok and his colleagues studied stock returns from April 1963 to April 1990. They took steps to avoid survival bias in the study, and focused on returns of up to five years on various strategies. They assumed annual buy and hold periods.
They found low book-to-market (glamour) stocks had an average annual return of 9.3%, while high book-to-market (value) stocks had an average annual return of 19.8%.
They also found that low cash-flow-to-price (glamour) stocks had an average annual return of 9.1%, compared with high cash-flow-to-price (value) stocks at an average annual return of 20.1%.
Low earnings-to-price (high p/e, i.e. glamour) stocks, they found, had an annual average return of 11.4% compared with high earnings-to-price (low p/e, i.e. value) stocks, which had an annual average return of 19%.
Companies with high growth in sales underperformed those with low growth in sales companies, with an average annual return of 12.7% compared with 19.5%.
When two of these measures were combined, the results persisted. For example, when past growth rate in sales and the cash-flow-to-price ratio were combined to classify stocks into growth or value portfolios, the high growth-in-sales, low cash-flow-to-price (glamour) portfolio had an annual average return of 11.4%, compared with the low growth-in-sales, high cash-flow-to-price (value) portfolio.
The results were similar for other combinations.
The study also showed the market is too optimistic about the future growth of glamour firms relative to value firms with respect to both cash flow and earnings.
For example, the professors said in their study, "the cash flow of glamour stocks grew 13.2% faster than that of value stocks, but, judging by the multiples, is expected to grow 19.9% faster per year."
"Given their expectations, investors are disappointed in the performance of glamour stocks relative to out-of-favor stocks," Mr. Lakonishok said.
He said the market is likely to learn about its mistake only slowly because its expectation of higher relative growth for individual glamour firms is often confirmed in the short-run and disproven only in the long-run.
Finally, using conventional measures of fundamental risk, value strategies appear to have been less risky than glamour strategies so that reward for bearing fundamental risk does not seem to explain higher average returns on value stocks than on glamour stocks, he said.
In their study, the professors said the extra returns on value stocks have persisted for so long possibly because investors did not know about them. Quantitative portfolio selection and evaluation are relatively recent activities, they said.
In addition, individual investors might focus on glamour strategies for several reasons. First, they might put excessive weight on the recent returns of these stocks. Or, they might equate glamour stocks with well-run companies, regardless of price.
Institutional investors might gravitate toward glamour stocks because they appear to be "prudent" investments that are easy to justify to sponsors who erroneously equate good companies with good investments.
Further, they said, most investors have shorter time horizons than are required for value strategies to pay off.
