Every now and then, a fad comes along that sweeps investors up in a whirlwind of hope and greed.
In the early 1970s, it was the "Nifty Fifty" craze. At the start of the 1980s, investors piled into biotech stocks. By the late 1990s, highflying Internet stocks were the latest Wall Street darlings.
Investors like to dream about huge returns, and they don't mind taking on a lot of risk to get them. But next time you get caught up in the next big thing, consider this: Value stocks have repeatedly outperformed growth stocks over the long haul.
When analysts talk about value stocks, they're generally referring to securities that are cheap relative to their fundamentals. These are often more mature companies that have fallen out of favor with investors yet pay a dividend and have a have low price-to-earnings ratio. Growth stocks, on the other hand, tend to be pricier and more popular because earnings and revenue are growing at a rapid pace.
In recent weeks, investors have shifted money out of growth stocks, which performed extremely well last year, and into some of the overlooked value stocks. Whether or not this trend will continue isn't clear, given the paucity of inexpensive issues currently trading on U.S. markets. But studies show that the rotation makes sense from a long-term perspective.
Finance professors Lewis Chan and Josef Lakonishok recently compared the performance of value and growth stocks using data from 1979 (when returns on the Russell indices became available) through the end of 2002. They found that the Russell 1000 value index posted an annualized return of 13.93%, compared with 11.84% for the Russell 1000 Growth index.
The evidence for small-cap value stocks is even more compelling. The Russell 2000 value index saw an annualized return of 14.74% compared with just 8.94% for the Russell 2000 growth index.
To prove that these numbers are valid and not simply the result of data mining, the professors also compared value and growth stocks across other countries and found similar results.
A number of other academics seem to agree with these findings. Professors Eugene Fama and Kenneth French have conducted various studies on the issue and consistently report that value stocks reap higher returns than growth stocks.
In their initial study back in 1992, the professors assembled 10 portfolios, each divided according to valuation multiples. They found that a value portfolio outperformed a growth portfolio by 1.53 percentage points each month.
Why does value produce superior returns? It could be because growth stocks are much more likely to disappoint investors, given the expectations built into them.
Because growth stories are more exciting, they tend to receive more media attention and more analyst coverage. In addition, investors often assume that because a company has had strong growth for a few years, it will continue to grow at a rapid pace for a long period of time. These factors raise expectations and increase the odds that the stock will fall if the company ever produces disappointing results.
Expectations for value stocks, on the other hand, are much lower. Companies that don't have an excellent record of earnings growth are not expected to provide excellent earnings in the future. These companies receive less attention from both the media and analysts, and they are often ignored by portfolio managers, which means the stocks get a big boost whenever positive news is released.
"The upshot of all these considerations is that value stocks become underpriced relative to their fundamentals," Chan and Lakonishok said. "Because these behavioral traits will probably continue to exist, patient investing in value stocks is likely to remain a rewarding long-term investment strategy."
Of course, there are times when value underperforms growth by a wide margin as was the case in 1998 and 1999. Studies show that value stocks perform better during periods of market turbulence or recessions. And while they have not historically underperformed during bull markets and periods of economic growth, the returns do tend to be smaller.
Because economic growth appears to be slowing and earnings momentum has peaked, some analysts say now might be a good time to snap up value stocks. "The equity environment says more caution" is required, said Donald Strazheim, president of Straszheim Global Advisors.
Still, Paul Nolte, director of research at Hinsdale Associates, says it's getting harder to find good value stocks. "We do struggle finding names, but a few pop up every once in while, like some of the food stocks ... and some of the health care names."
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Charles Rotblut, director of financial content at InvesTools, said the market has been rallying indiscriminately since last March, and says that has left few stocks with discounted valuations.
"As a value investor, I'm having problems finding stocks that are both fundamentally strong and are trading at compelling valuations," he said. "In the current market, investing either means paying up or sitting on the sidelines."