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 March 2007 The Value Conundrum Are Value Stocks Inherently Riskier?
Diversification can help control risk through the combination of uncorrelated assets. While it can moderate portfolio risk, it still doesn't diminish the market risk of each individual component when taken in isolation. Riskier assets remain risky regardless of how you combine them. Another common belief is that value stocks generally outperform growth. This isn't quite as widely accepted as the correlation between risk and return and it doesn't always hold. In any given year, growth stocks may end up on top, but the belief is that value tends to lead over the long-term.
Value investors certainly believe this, some almost religiously. Even some growth investors grudgingly acknowledge that value has occasionally led for prolonged periods. Most recently, value's been on top for seven straight years. So here are two widely accepted beliefs, but when they're taken together, the results are less than intuitive: Either value stocks are inherently riskier than growth, or at least in this case, risk and return aren't directly related. Neither of these alternatives is particularly appealing. Almost no one doubts the relationship between risk and return yet most believe value stocks are actually less risky than growth. Something's got to give, but what?
Risk and Return The S&P Value and Growth Indexes are one of the best measures of style performance. Unlike Russell which allows the same issues to appear in both value and growth indexes, the S&P indexes are exclusive. We focused on the large cap S&P indexes covering the period 1983 - 2006. This wasn't an arbitrary decisions but rather reflects the extent of the data available through Baseline.
The first and somewhat surprising discovery was that although value seems to dominate for longer periods of time, it's actually growth that had the slight edge over the entire 23-year period (see Chart 1). Much of this was attributable to growth's remarkable runup in the mid to late 1990s. That sharp divergence last decade also helped growth achieve a higher average monthly return over the period (0.90% vs. 0.83%). That's not exactly value dominance. Nevertheless, value did set the pace for longer periods than growth. For example, value was the leader for 24 months from September 1987 through August 1989, as well as the 21 months from January 1992 through September 1993. Growth's longest run extended from June 1998 to December 1999. Yet the length of dominance doesn't always translate into return. For example, although value beat growth in 15 of the 24 months between September 1987 and August 1989, growth still finished the period ahead by 4%. This attests to the fact that even if value leads in more months, growth often more than makes up for it with stronger outperformance in the months it wins. Chart 2 shows the longest periods of dominance as well as the difference in style performance for each. For the most part, value led for longer periods of time, but by a smaller amount. Growth's tech-bubble runup is a prime example of sharp outperformance for shorter periods of time. This is the tortoise and hare type situation with value plodding along for longer periods while growth speeds ahead in shorter ones. Despite all this, both styles finished the 23-year period in roughly the same place. They took different paths to get there, but ended up together.
Since they both have roughly the same period return, neither really dominates the other. Each has its turn in the limelight, but neither runs away with it. For the 277 months from November 1983 - December 2006, value had the slight edge in months (138 vs. 136) with three ties. That's effectively a dead heat. Although the returns are about the same, they were achieved in distinctly different ways. As already suggested, growth tends to have wider swings over shorter periods. This is borne out by the numbers. For example, over the sample period, growth's best and worst months ranged from +14.0% to -23.2%. Value was somewhat less volatile, with extremes of 13.2% and -20.7%. This suggests growth is actually riskier than value.
What Mystery?
So where's the mystery? Returns are roughly the same while growth has slightly higher risk. What happened to that perceived value dominance? And if it doesn't exist, it's no wonder value isn't riskier than growth. Investors often fall prey to the mistake of extrapolating current conditions far into the future. For example, value outpaced growth in 10 of the 13 months ending December 31, 2006. Over the period, value has returned a cumulative 15.5% vs. 12.0% for growth. Given today's short-term focus, that's almost an eternity and it's easy to believe it will always be this way. But this has happened in the past and leadership has always changed. You can never be sure when it will happen, but it will. The one thing you can be sure about is that the value conundrum doesn't really exist. The numbers don't lie. Search this site! Just enter you key word or words:
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NE OF THE FIRST THINGS an investor learns is that there is a direct relation between risk and return. The riskier the asset the greater the potential return. Conversely, top-returning assets tend to be riskier than their lesser-performing alternatives.
