Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 123

Irrational exuberance in growth versus value

Now is a good time to remember the lessons of history about growth shares versus value shares.

Imagine that your rich aunt has passed away and left you a parcel of shares, but you must make a choice, and there is a condition. The choice is between receiving either $1 million worth of Amazon shares or $1 million of Walmart shares. The condition is that you can never sell the shares. You can only receive the dividends from the chosen parcel in perpetuity. Which would you prefer?

This choice comes to mind because recently Amazon became a more valuable company than Walmart. The market capitalisation of Amazon is $244 billion versus $230 billion for Walmart (all figures in USD).

If we didn't know better, we might think that since the market value of the two companies is similar their profits must be similar. But in fact in 2014 Walmart's net income was $15.7 billion whereas Amazon lost $0.2 billion. In its whole 20 year history the cumulative profits of Amazon are less than $2.0 billion. In the last 50 days Walmart has made more money than Amazon has in the last 20 years.

Figure 1: Return premium of Value stocks over Growth stocks, US 1927-2013

SW Figure1 210815 cropped

SW Figure1 210815 cropped

Source: Dimensional Fund Advisors

The graph shows, for each year, the return on a portfolio of the 20% of US stocks that have the strongest 'value' characteristics minus the return on the 20% of stocks with the strongest 'growth' characteristics. US stocks have 'value' phases (blue) when value stocks outperform and 'growth' phases (red) when growth stocks do better, but on average value stocks deliver much higher returns over time.

Give me the Walmart dividends

Obviously, the stock market is ignoring the difference in today's earnings and focusing on the higher expected growth in earnings of the two companies. The market sees a bright future of rapidly growing earnings for glamorous, high tech, disruptive Amazon and dim growth prospects for boring, old economy, sitting duck Walmart.

That may be so, but I will take the Walmart shares thanks. I want today's big Walmart dividends ($27,000 annually) versus the promise of large dividends from Amazon in the future.

We can't see into the future to which stock will outperform. But we can see into the past to the historic record of stock returns and that record is very clear - in the long run 'value' stocks like Walmart have higher returns than 'growth' stocks like Amazon.

Definition of value and growth

'Value' stocks are defined by their low share price relative to some objective measure of value. The share price of value stocks is low relative to:

  • Dividends (a high dividend yield)
  • Earnings (a low price to earnings (PE) ratio)
  • Book value of equity (a low market value to book value ratio).

'Growth' stocks are the opposite to value stocks.  That is, growth stocks have low dividend yields, high price-to-earnings ratios and high market value to book value ratios. High PE ratios are especially indicative of 'growth' stocks.  Investors who will pay a high share price today per dollar of today's earnings must be expecting substantial growth in earnings in the future.

The graph above shows that, on average, across stocks and through time, value stocks outperform growth stocks by a lot. That is not only true for US stocks but around the world. There is no bullet-proof theoretical explanation for why value stocks outperform growth stocks in nearly every country and through time (on average), but it is an undeniable regularity in the data.

The best explanation (to simplify somewhat) is that investors get too excited about stocks in new glamorous industries that are expected to deliver large dividends in the future. Those stocks on average don't deliver the expected dividends and then growth stocks underperform. Investors pay too much for stocks that promise large growth in dividends.

Value phases and growth phases

There are periods of multiple years in which excitement about growth stocks bids them up and they outperform boring value stocks that pay high current dividends but have low growth prospects. The US market may be in such a period now with digital technology stocks like Amazon, Facebook or Netflix.

So now is a good time to remember that investors who don't buy into over-hyped growth promises earn higher returns in the long run. That is an enduring lesson of not just the history of stock markets, but property market investments as well.

 

Dr Sam Wylie is a director of Windlestone Education and a Principal Fellow of the Melbourne Business School. Sam consults and teaches programmes for corporate and government clients and can be contacted on LinkedIn here. This article is for general education purposes and does not address the needs of any individual investor.

4 Comments
David Bell
August 25, 2015

Hi Sam, I always find articles on value and growth stocks interesting but I have concerns about the way you have defined 'growth' stocks. In my opinion 'growth' stocks are companies whose earnings are growing fast or are forecast to grow quicker than the earnings of other companies. To me it appears that you have defined 'growth' stocks to be the opposite of value stocks, namely expensive stocks. This may not always be the case: stocks can be expensive for many reasons. It could even be possible that there are some stocks out there which appear cheap and have growth characteristics. If in your analysis you have defined 'growth' to have simply the opposite characteristics of 'value' stocks then in my opinion this could potentially be a flawed analysis. I am unsure however what makes up your chart - could you clarify please.
Regards, David

Sam Wylie
August 25, 2015

Hi David
The main way that people define growth stocks is by the PE ratio. Growth stocks have high PE ratios, which means that investors are willing to pay a lot today per dollar of today's earnings. They do that because they are expecting growth in earnings in the future. That is the most standard meaning of 'growth'.
Cheers
Sam

Gary M
August 21, 2015

A couple of points. 1) You picked a mature star (Walmart) and a company that spends more than it earns (Amazon). It would be better to have at least picked a decent non-dividend paying star (like Google). Amazon may never be profitable.

2) Then that opens up the debate about what dividends actually are. They are not ‘income’ (apart from in a very narrow accounting sense in the eyes of the recipient only). Dividends are capital and they reduce the future growth and earning capacity of the company.

Sam Wylie
August 25, 2015

Hi Gary
We should look beyond any specific examples to the average over all growth stocks and all value stocks. Then the record is very clear. Value strategies outperform growth strategies in the long run.
Cheers
Sam

 

Leave a Comment:

     

RELATED ARTICLES

Single-period measures do not work for great growth companies

Seismic change and investing in barbells

Why valuation multiples fail in an exponential world

banner

Most viewed in recent weeks

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Latest Updates

Retirement

Stop treating the family home as a retirement sacred cow

The way home ownership relates to retirement income is rated a 'D', as in Distortion, Decumulation and Denial. For many, their home is their largest asset but it's least likely to be used for retirement income.

Property

Hey boomer, first home buyers and all the fuss

What is APRA worried about? Most mortgagees can easily absorb increases in interest rates without posing a systemic threat to the banking system. Housing lending is a relatively risk-free activity for banks.

Property

Residential Property Survey Q3 2021

Housing market sentiment has eased from record highs and confidence has ticked down as house price rises slow. Construction costs overtook lack of development sites as the biggest impediment for new housing.

Investment strategies

Personal finance is 80% personal and 20% finance

Understanding your own biases and behaviours is even more important than learning about markets. Overcome four major cognitive biases that may be sabotaging your investing and recognise them in others.

Where do stockmarket returns come from over time?

Cash flow statements differ from income statements and balance sheets, and every company must balance payments to investors versus investing into the business. Cash flows drive the value of the business.

Fixed interest

How to invest in the ‘reopening of Australia’ in bonds

As Sydney and Melbourne emerge from lockdown, there are some reopening trades in the Australian credit market which 'sophisticated' investors should consider as part of their fixed income portfolios.

Shares

10 trends reshaping the future of emerging markets

Demand for air travel, China’s growing middle-class population, Brazil’s digital payments take-up, Indian IPOs, and increased urbanisation are just some of the trends being seen in emerging economies.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.