Lecture 3:Equity investing styles

• Some investors (specifically, investment managers) tend fol-low particular investment styles

• An investment style is, roughly, the emphasis placed on par-ticular characteristics of stocks included in the portfolio

• No single style is universally superior, and none guaranteesfuture returns

• Here, we look at the most representative and popular ones:growth & value

Style Value GrowthStock type “bargains”, or stocks

that trade at a lowprice relative to their

fundamentals

stocks that offerslarge growth

potential (and maytrade at a premium)

Characteristics low P/E ratio, lowP/Book ratio, etc

high P/E ratio, highP/Book ratio, etc

Rationale Belief that themarket has mispricedcompanies and a

correction will moveprices up and

generate returns.

Investors who followthis route generallybelieve that thefuture growth will

lead to stockoutperformance.

Growth vs. value explained

What sets value investors apart is the goal of payinga bargain price for the assets the company hasin place; as opposed to growth investors, who aim toidentify exceptional growth opportunities.

(Damodaran, Aswath, Value Investing: Investing forGrown Ups? Working Paper, 2012.)

In this lecture, we will try to understand which strategy performsbetter, and why!

The first question we need to ask is how to build a consitentvalue or growth strategy.

We mentioned above that value and growth stocks can be iden-tified using price multiples. The two most consitently used:

• P/E, or price-to-earnings: the most often used ratio, theratio is simple to calculate and use, and has the advantagethat it can be applied across all sectors, but:

– is distorted when earnings are too close to zero, andcannot be used when the company is making a loss;

– accounting earnings vary in quality from company tocompany.

• P/B, or price-to-book value: explains stock returns morethan any other fundamental variable, much more stable andless exposed to the uncertainties in estimates necessary tocalculate the earnings number.

It turns out that irrespective of which metric we use, valueseems to outperform growth.

To set up the strategy we simply create a portfolio comprising stocks with 20% highestand lowest scores on each metric. Here’s what the empirical evidence says:

So now we know that value trumps growth. But why? Specifi-cally:

• is the outperformance of value driven by a simple risk/rewardstory? (ie, investors take more risk when investing in valueand to compensate for this risk are rewarded with largeraverage returns); or

• are the returns of value and growth investment strategies aconsequence of mispricing? (i.e. the market often overreactswhen value names fall out of favour and excessive hype isbuilt around growth names).

Diving deeper into the performance of value stocks, we start bybreaking down returns on a single stock into its components.

Returns can be divided into Dividend Yield and Capital appreci-ation:

(1 +Returnperiod) =Dividendsperiod

Pstart+ PendPstart

And capital appreciation, in turn, can be divided into earnings growth and earningsrerating:

(1 +Returnperiod) =Dividendsperiod

Pstart+

EarningsendEarningsstart

× P/EendP/Estart

Hence:

(1 +Returns) = Dividend Yield + [(1 + Earnings growth) × (1 + P/E rerating)]

Value stocks, almost by definition, are expected to have higherdividend yields. Indeed:

Growth stocks, again almost by definition, are expected to havehigher earnings growth. And in general that is what we find inthe data: in 11 of the past 13 years growth stocks had higherEPS growth than value names...

... but the EPS growth advantage that investors received forgrowth stocks is not as consistent or high in magnitude as thedividend yield advantage value investors received for their invest-ments.

Let’s now look at the third component of returns: P/Ererating

The P/E rerating works as a multiplier which defines how muchthe earnings growth affects the capital appreciation/depreciationof the investment.

Suppose that an investors buys $100 of a stock and holds it forone year; and when the position is opened the stock has EPS= 10 and trades at a P/E = 10x. Now let us assume this stockdoubles its EPS over the year. In this case the invested capitalwill only double if P/E stays put at 10x. But if the stock’sP/E rerates to 15x the capital will actually treble (i.e. whenthe position is closed: EPS $20 * P/E 15x = $300) while, ifthe P/E de-rates to 5x the capital appreciation will be zero (i.e.when the position is closed: EPS $20 * P/E 5x = $100).

Rerating dilutes the returns of growth and boosts returns of valuestocks. (For academic research on this effect see The Anatomyof Value and Growth Stock Returns, Fama & French, (2007))

Two conclusions follow:

Iwhile growth stocks benefit from stronger EPS, growth stockstend to rerate negatively: as their earnings grow, the value themarket attaches to these earnings is constantly falling; growthcompanies consume their growth opportunities quickly causingPEs to fall, so limiting the returns on investing in growth names.

IThe reverse is true of value names, which show (often strong)positive rerating in most years; hence, even in the face of theweaker earnings growth shown by these stocks, the rerating addsto the higher yield and generally translates into outperformanceof value stocks.

We now know that value tends to outperform growth and how itdoes so. The only remaining question is: why?

There is some evidence that value simply carries more risk thangrowth:

This evidence lead Fama and French to formulate their famous 3-factor extension ofCAPM:

I CAPM: Rs −Rf = α + β × (Rm −Rf )

I F&F 3 Factor model: Rs −Rf = α+ β × (Rm −Rf ) +H × HML +S ×SMB

HML is the ‘high minus low’ book to price factor (which is measured based on thehistoric outperformance of low P/B over high P/B stocks) and SML is the ‘small minuslarge’ size/liquidity factor (which is measured based on the historic outperformance ofsmall cap over large cap stocks).

So, while the CAPM argues that beta and the excess return on the market alone are ableto explain single stock returns; the FF 3 factor model states that valuation (as capturedby the price to book ratio) and stock liquidity/size also impact returns.

Risk may be one explanation, but there is also another, capturedin this quote:

“Value investing strategies have worked for years andeveryone’s known about them. They continue to workbecause it’s hard for people to do, for two main reasons.First, the companies that show up on the screens can bescary and not doing so well, so people find them difficultto buy. Second, there can be one-, two- or three-yearperiods when a strategy like this doesn’t work. Mostpeople aren’t capable of sticking it out through that.”

(Quote attributed to Joel Greenblatt - Columbia University pro-fessor and founder of Gothan Capital)

In other words: value investing often means contrarianinvesting. When buying companies that are trading at cheapvaluations investor must be ready to weather the storm and con-tinue to hold companies for longer time horizons.

Companies in a value basket will often be companies about whichthere are no good news for extended periods, companies thatdisappoint on earnings, companies being affected by economic

or political turmoil, etc. Hence, holding value stocks fora longer time horizon is necessary since many of thesestocks will need a significant amount of time for thereasons that made them cheap to reverse.

We can test this by looking at whether the returns of value (lowP/E) stocks are affected by the frequency of portfolio rebalanc-ing.

Here’s the bottom line:

Ithe value strategy outperforms the market by 2.4% annu-alised when rebalanced every 12 months, and the quarterly rebal-ancing basket by 0.5% annualised.

Ithe same strategy underperforms the market by 2.1% annu-alised when rebalanced every month!

So not only does the P/E strategy rebalanced every month un-derperform the screen rebalanced every year, but the quick re-balancing turns a winning strategy into one that underperformsthe general market as well.