
Value versus Growth Investing
Although growth stocks have outperformed value stocks over certain
time periods, this trend has not always prevailed over longer
periods. For the two-year period 2003–2005, value stocks outperformed
growth stocks, giving value stocks the appearance of
being overvalued. Consequently, an investor looking for value
might consider buying growth stocks because he or she would pay
a small premium for them. Therefore, should investors continue to
choose the leadership in the sector that is doing well and ignore
the other lagging sectors of the market? It is easier to answer this
question for a long investment period, but over the short term, it
becomes more of a guessing game. The momentum investing style is
to jump into those stocks that have been going up in price. The
major problem with momentum investing is that the turning point
can never be predicted accurately. These leadership stocks eventually
will become laggards, and the rotation will shift into the other
sectors of stocks. If one is investing in these leadership stocks at
the top of their price cycles, the returns may be not be positive
for some time before they come back into favor. Over the long
term, investors who have diversified portfolios of stocks among
the different sectors (small-, mid-, and large-cap value and growth
stocks) will see steadier returns.
An analysis of the stock market substantiates this premise.
Over the 26-year period 1979–2005, there were times where value
stocks outperformed growth stocks and where the opposite occurred
(growth stocks outperformed value stocks), as summarized in
Table 13–2.
Which stocks over a long-term period would have returned
more to investors? The answer may be surprising. A study done
by David Leineweber and colleagues reported that $1 invested in
both value and growth stocks, as followed by the price-to-book
value of S&P 500 Index stocks during the period 1975–1995, would
have resulted in $23 for value stocks versus $14 for growth
stocks (Coggin, Fabozzi, and Arnott, 1997, p. 188). These results
also have been confirmed by studies done on foreign stocks. A
study done by Capaul, Rowley, and Sharpe (1993, p. 34) determined
that value stocks outperformed growth stocks abroad
(France, Germany, Switzerland, Japan, and the United Kingdom)
during the period January 1981–June 1992. Jeremy Siegel, a professor
at the University of Pennsylvania, found that value stocks
outperformed growth stocks over the 35-year period between July
1963 and December 1998. Value stocks earned 13.4 percent annually,
whereas growth stocks earned 12 percent annually (Tam and
McGeeham, 1999, pp. C1, C19).
Table 13-2
Performance of U.S. Stocks Over the Period 1979–2005

In short, this phenomenon—value stocks outperforming
growth stocks over long periods—should have some significance
in the choice of stocks for investment portfolios. The evidence
shows that winning stocks do not keep their positions over time;
they revert to the mean. Similarly, losing stocks do not remain
losers over long periods of time because they too rise to the average.
In other words, the high-flying value stocks of today will
not be able to sustain their abnormally high returns, and they will
turn into stocks with lower returns, and the low returns of the
growth stocks of today eventually will surprise investors with
higher returns.
This phenomenon of returns reverting to the mean over time
can be applied to small- and large-cap stocks as well. However,
small-cap stocks outperformed large-cap stocks during the periods
1974–1983 and 1991–1992. Investing in small- and mid-cap stocks
from 1996 to 2000 would have resulted in either below-market or
negative returns. Inevitably, though, small-cap stocks outperform
large-cap stocks on a risk-adjusted basis over long periods. The
second reason to include small-cap stocks in a diversified portfolio
is that small-cap stocks have relatively low correlations with
large-cap stocks, thereby improving the risk/return statistics in a
portfolio.
Adding mid-cap stocks to small- and large-cap stocks in a portfolio
reduces the volatility risks and optimizes the stability of returns.
Many market timers consider that this style of investing across different
sectors weakens the potential returns they could have achieved
by moving with the top-performing sectors. Obviously, a diversified
portfolio will not gain as much as the strongest-performing sector or
fall as much as the weakest-performing sector. The results for market
timers depend on their accuracy in timing their calls to move in and
out of the different sectors. Your overall choice of whether to be an
active or a passive investor and your motivation for the choice of
equity style ultimately will depend on your outlook on the market
and your specific makeup with regard to risk and return.
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