(AIG) Style Anomaly: Value versus Growth

Summer is heating up and some of the greatest baseball rivalries are in full swing. Think Cubs v Cardinals, Red Sox v Yankees and Dodgers v Giants. In the world of stock investing, however, the greatest rivalry is value v growth.

One often hears how value stocks outperform growth stocks; hence the value stock anomaly. But, does one set of stocks, on average, really outperform the other? Which style is experiencing a current streak? How long has the trend lasted? When is it due for a reversal?

First, let’s define value and growth. Typical methods for defining these styles include the Earnings-to-Price (E/P) ratio and the analyst estimated 3-5 year growth rate (EGR). I like to use E/P instead of P/E because earnings can be negative and value strategies denote high earnings and low price. Therefore, value is described as either high E/P or low EGR and growth is identified as low E/P or high EGR.

To see if a portfolio of high earnings and low price stocks is similar to a portfolio of low estimated growth, I looked at returns to value stocks defined as high E/P and those defined as low EGR. The correlation of the returns to these two portfolios was 96%. As a result, the value stock effect can be measured using either of these classifications. The same check was conducted with each measure creating growth stock portfolios, which resulted in a 92% correlation. Consequently, either definition also captures the growth stock effect. Since the correlations between these parameters are high, let’s move forward with distinguishing value and growth by E/P.

Starting out with a universe of the 3000 most liquid stocks, I tested a value stock portfolio (300 stocks with the highest E/P) and a growth stock portfolio (300 stocks with the lowest E/P) from January 2000 – May 2011. I chose 300 stocks in each portfolio to ensure capture of the value/growth effect and to reduce the impact of extreme returns possible in smaller portfolios.

The results over those 11+ years indicate a tendency for value stocks to outperform growth by an average of 1.2% per month for an annualized return of 11.1%. These results demonstrate that the value anomaly does exist over the long term. But, there’s often a reversal that can occur fairly quickly. The market switches its preferred style on average every three months. The growth trend lasts on average 7.8 weeks and the value streak lasts longer at about 13.2 weeks.

However, over the last three years, growth and value stocks have been in a death grip with growth minimally outperforming value stocks to the tune of 0.4% a month. This even holds true for the last 12 months. Typically, growth stocks tend to outperform value stocks during periods of economic uncertainty since “growth” implies the companies are increasing their revenue and earnings despite economic conditions. So it’s no surprise that the current trend is to favor growth stocks. As the economy begins a definitive expansion, one might expect value stocks to regain their favored status.

This study provides evidence of the value anomaly and demonstrates that value outperforms growth over the long term. Yet, remember that many reversals do occur, and they are often determined by economic conditions.

For example, over the past three years, growth has taken a slight lead over value. The rationale for the value anomaly’s existence over time may lie in investors overpaying for glamour stocks with sexy stories and lofty expectations. Often it’s the more practical value stocks, which are oversold or experiencing temporary difficulties, that provide for better returns in the end. The value anomaly is another example of the market not being able to properly reflect current conditions and future expectations in current stock prices.

Here is a method for finding stocks to take advantage of the value anomaly:

  • First, create a liquid, investible set of the stocks with the largest 5000 market values and average daily volume greater than or equal to 100,000 shares (if there’s not enough liquidity, it’ll be hard for you to trade it).
  • Next, select only those with an Earnings-to-Price > 0.11 (remember, we want high earnings to price).
  • Now add an additional value filter and select those with a Price-to-Sales ratio less than 0.8 (we want stocks with a low Price-to-Sales).
  • Finally, add a further value factor selecting only those stocks with a Price-to-Book ratio less than 0.9 (we want stocks with a low Price-to-Book).

Here are 5 stocks for a true value play (06/15/11):

AIG American International Group, Inc.

MET MetLife, Inc.

DB Deutsche Bank AG

CSC Computer Sciences Corporation

IM Ingram Micro Inc.

The value anomaly is just one of many types of investment anomalies. Other examples might include anomalies based on analyst data, insider trading and earnings surprises. To explore the world of stock investing anomalies, please visit a website dedicated to their explanation and discussion: hema.zacks.com. You’ll be glad you did.

Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.

Disclosure: Performance information for Zacks’ portfolios and strategies are available at: http://www.zacks.com/performance.

AMER INTL GRP (AIG): Free Stock Analysis Report

COMP SCIENCE (CSC): Free Stock Analysis Report

DEUTSCHE BK AG (DB): Free Stock Analysis Report

INGRAM MICRO (IM): Free Stock Analysis Report

METLIFE INC (MET): Free Stock Analysis Report

Zacks Investment Research

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