Joel Chernoff
10 July 2000
Pensions & Investments
Value managers, take heart.
There's hope on the horizon for traditional value and small-cap strategies, according to a study slated for publication in the July/ August issue of the Financial Analysts Journal.
While the performance of large-cap growth stocks has far surpassed value stocks in the past few years, there is little support in traditional data -- such as sales growth, earnings growth and dividend growth -- for growth stocks continuing their domination.
According to the paper by Louis K.C. Chan and Josef Lakonishok, finance professors at the University of Illinois at Urbana-Champaign, and Jason Karceski, a professor at the University of Florida's business school, the outperformance by large-cap growth stocks is unsupported by other financial measures.
"Maybe it is investor sentiment, wishful thinking, whatever, but we don't think it's rational," said Mr. Lakonishok in an interview. Mr. Lakonishok also is chief investment officer of LSV Asset Management, Chicago, a deep-value equity manager.
Unjustifiable valuations
In a second swat at growth stock prices, Messrs. Chan, Lakonishok and Karceski found that recent valuations of many growth stocks are unjustifiable. (Many growth managers, however, believe fundamental shifts in the economy caused by new technologies make previous valuation measures inappropriate.)
For example, a company with a price-to-earnings ratio of 100 would have to generate annual growth of 29%. But only the top 2% of companies grew more than 27.6% a year during rolling five-year periods from 1960 through 1998, according to their research.
"Maybe 2% to 3% of companies will (hit a 29% growth rate), but we really have to be lunatics to think we can identify those companies," Mr. Lakonishok said.
Meanwhile, vaunted technology companies, such as Cisco Systems Inc. and Yahoo! Inc., have p/e multiples well over 100.
Yahoo, with a p/e of 348 and a price of $123.56 on June 28, would need an implied growth rate of 78% per year. That's based on the assumptions that the stock returns 9% rate of return for the next five years, and the p/e slips to a historical norm for growth stocks of 30 in five years' time.
In the 1980s, value and small-cap strategies were the winning styles, but they have come up short in later periods.
For example, small-cap value stocks enjoyed a mean return of 21.7% a year in the 1980s, while large-cap value stocks returned 19.4% on an annualized basis. From 1980 to 1989, large-cap value stocks outperformed their growth counterparts by 4.5 percentage points per year, the paper said.
Based on that experience and an influential 1992 paper by Eugene Fama and Kenneth French, investors started focusing on small-cap and value stocks.
But "the tables began to turn" in the 1990s, as large-cap stocks started winning the performance sweepstakes, the authors wrote. In the 15-year period from 1984 through 1998, the Russell 1000 index of large-cap stocks retuned 17.71% annually compared with 11.22% for the Russell 2000 index of small-cap stocks.
In recent years, large-cap growth stocks have vastly outperformed their small-cap equivalents. For example, for the five-year period through 1998, large-cap growth stocks returned 28.3% a year vs. 11.3% for small-cap growth stocks, using modified Russell universes.
Value stocks also have withered, lagging growth stocks by an average of 1.1 percentage point per year from 1990 through 1998. Average underperformance hit 3.3 percentage points for the 1996 to 1998 period.
And, as all managers know, things did not improve in 1999. For example, the Russell Midcap Growth index returned 51.3%, compared with a -0.1% return for the Russell Midcap Value index.
Because many managers are more tilted toward midcap stocks and are relatively less growth-oriented than the Standard & Poor's 500 stock index, their performance suffered. Many value managers have been pressured to incorporate growth stocks into their strategies.
Rebound or real change?
The question, then: will value stocks rebound or has a long-term change taken place?
The paper explores three competing explanations for the recent outperformance of large-cap growth stocks:
* "Rational" asset pricing models say large growth stocks experienced a series of unexpected positive shocks, perhaps inspired by technology, changes in corporate control mechanisms or revisions in profit expectations, while small stocks lagged because of prolonged negative surprises. If the recent past represents a string of temporary shocks, small-cap stocks and value stocks will rebound.
* The "new paradigm" argument says market prices have not fully incorporated the future benefits of technology, and superior returns for large growth stocks will persist for some time.
* Behavioral considerations say that investors have overreacted, lured by the stock market's rise, ready availability of financial information, and popularity of 401(k) plans. This suggests small and value stocks will recover, but it is not clear just when.
To check out these theories, the authors compared stock performance against several variables, and found the high valuations of large-cap growth stocks were unjustified.
While large-cap growth stocks returned an average 34% a year for the 1996-'98 period, small-cap value stocks returned an average 19.7% during that period, yet enjoyed sales growth of 12.7% a year -- more than twice the 6% rate of large-cap growth stocks, the paper said.
Smaller sales growth
The rational pricing and new paradigm hypotheses suggest large-cap growth stocks would have experienced extraordinary gains in operating performance, the paper said. However, 6% annualized sales growth for the three-year period was far lower than the 10.3% average for such stocks over the entire 29-year period, the authors wrote.
In comparison, net sales of small-cap and midcap value stocks enjoyed robust growth in the three-year period ended Dec. 31, 1998, the paper said. Sales grew by 12.7% and 9.7% a year for the small-cap and midcap portfolios, respectively, vs. 8.1% and 7.5% annualized growth for the entire 29-year period.
Neither measures of profitability nor dividend growth justify the high prices for growth stocks using operating income before depreciation.
While a long-term change in historical returns is possible, Mr. Chan said in an interview, "I think it would be rather implausible given the patterns we have seen in the data."
If investment performance returns to historic experience, as so far appears evident this year, "small-cap and value investors will be vindicated and make a successful comeback," the paper said.