This In Practice piece gives a practitioner’s perspective on the article “Fundamentals of Value versus Growth Investing and an Explanation for the Value Trap,” by Stephen Penman and Francesco Reggiani, published in the Fourth Quarter 2018 issue of the Financial Analysts Journal.
What’s the Investment Issue?
Two of the most prominent investing styles are “value” and “growth.” Value investors target stocks with low multiples—for example, high earnings-to-price ratios (E/Ps) (i.e., the inverse of low P/Es) and high book to price ratios (B/P). Growth investors target high multiples.
But what do these labels actually represent? Value is often perceived to represent a “cheap” stock—that is, a stock trading at a price lower than its fundamentals. Growth is often perceived to indicate higher future earnings and a low P/B. Historically, value stocks have outperformed growth stocks. But the former can turn against investors—in a so-called value trap. In the last few years, they have performed relatively poorly. The aim of the study is not just to add more evidence around the value trap but also to explain why value connects to low profitability.
The key, the authors say, is to recognise that these multiples are accounting phenomena. To understand the investment risks inherent in them, investors need to consider the relationships in the accounting that underpins earnings and book value.How Do the Authors Tackle the Issue?
The authors start by documenting the historical returns achieved by value and growth investing. They look at firms on Compustat between 1963 and 2015 and group them into five portfolios from low to high E/P. Each of these are then divided into a further five portfolios, from low to high B/P. They tabulate the average annual investment returns of all 30 portfolios (before transaction costs) across these dimensions, for both equally weighted returns and value-weighted returns.
Next, they test their hypothesis that accounting phenomena may help explain if and how E/Ps and B/Ps are indicators of risk. They look mathematically at how earnings and book value are measured, using a standard pricing formula and the “realization” principle in accounting—an application of “conservative accounting,” which instructs accountants to recognise revenue only once its receipt is reasonably certain.
The authors illustrate their analysis with historical case studies from six publicly traded companies. They then attempt to confirm their conclusions by testing empirically whether E/P and B/P are related to growth and risk by tabulating earnings growth rates two years ahead for their portfolios. Finally, they examine how their conclusions change when comparing small and large firms.What Are the Findings?
The analysis from 1963 to 2015 reveals that as E/P and B/P increase, returns increase. The return spread between the portfolio with the lowest E/P and B/P and that with the highest is 25.2%. The value-weighted results show similar trends. The authors note than this spread looks too large for such a simple strategy to be a free lunch and cannot be explained by transaction costs.
By mathematically connecting E/P and B/P to growth and risk, they establish three conditions. Together, these state that for any given E/P, B/P is positively related to both expected earnings growth and the required return for risk—if a lower return on equity implies higher future earnings growth. They show that this inverse relationship can be explained by the realization principle. Put simply, because of conservative accounting, a low ROE implies higher growth and risk at a given E/P. Conversely, a high ROE comes from the realization of earnings growth and a lower risk. The historical case studies they examine provide evidence for these conclusions.
Testing these conditions empirically, the authors find that for a given E/P, B/P is positively correlated with future growth, which means that the return spread they find is explained by buying future earnings growth. But B/P also indicates the variance around that expectation.
The authors show that B/P is more effective at predicting returns for small firms than large ones and that E/P much more important than B/P in predicting returns for large firms. They explain this finding via the relative exposure of the two groups to growth at risk: It is intuitive that small firms are more likely to be risky growth prospects.
Their analysis concludes that despite their prominence, the common labels of value and growth can be misleading. A low B/P—commonly considered to signal growth—does not necessarily mean higher expected earnings growth. Crucially, ROE—the earnings associated with the book value—enters the equation.What Are the Implications for Investors and Investment Professionals?
The authors argue that investors should be cautious of the standard labeling of value and growth based on buying low or high pricing multiples. An investor pursuing a value strategy by targeting a high E/P (or low P/E) stock could in fact be buying a stock with high growth expectations where growth is risky—characteristics that fly in the face of the fundamentals of value investing. This can lead to a value trap.
By also considering B/P, the investor is better placed to understand the risk. When considered alongside E/P, a high B/P implies higher future earnings growth—contrary to the standard view that it is low B/P that buys growth. Moreover, high B/P stocks are vulnerable to more extreme shocks to growth, making them more risky. The authors emphasise that because earnings and book value are measured using accounting principles, these multiples should be applied together in any investment strategy based on pricing ratios.
This study can help investors by illuminating the differences between the worldviews of accountants and investors. The former is backward looking, because earnings add to book value but have to go through accounting. But markets price this in at an earlier stage; they are forward-looking. These different worldviews are reflected in E/P and B/P multiples and their different pricing of growth and value.