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The King is Dead. Long Live the King!

By: Andrew J. Willms

President and CEO of The Milwaukee Company


In their highly influential 1992 paper entitled “Common Risk Factors in the Returns on Stocks and Bonds”, University of Chicago professors Eugene Fama and Kenneth French found that:


(i) Value stocks (that is, stocks with low multiples of price to earnings or book value per share) tend to outperform growth stocks (companies expected to grow at significantly above-average rates), and


(ii) Stocks of smaller companies tend to outperform large-cap stocks.


Accordingly, all else being equal, a portfolio comprised of stocks issued by small companies and firms with low price-to-earnings ratios will have higher expected future returns than a portfolio consisting of large-cap and high price-to-earnings ratio stocks.[1]


That was then, this is now. Since the paper was written, academics have identified several dozen risk factors that supposedly explain why certain market sectors have a history of generating higher returns than the market overall. Meanwhile, value stocks have persistently underperformed growth stocks.[2] As a result, market commentators have been proclaiming the death of the value factor for many years.

Yet recent history suggests otherwise. Value stocks have soared lately, while growth stocks have struggled. In fact, the largest rotation out of growth into value on record occurred just this past November 9. To repurpose Mark Twain’s famous observation, reports about value stock’s, death appear to have been greatly exaggerated.


There are several possible reasons for what appears to be a resurrection of value stocks. One is that value stocks have become very inexpensive relative to their growth counterparts. Consider: growth shares now trade at an average price-to-earnings ratio of 38 times vs. value stocks at 17 times. In other words, value stocks offer more value than growth stocks at the moment.


Additional support for the resurgence of value stocks is provided by the principle of mean reversion – the proposition that over time, prices tend to revert to their historical average. Said differently, because stocks with lower price to earnings or book-value multiples have trailed growth stocks for a long time, odds are favorable that the laggards will continue to outperform until they catch up.


No matter how you look at it, no one knows for sure whether value stocks will be able to sustain their recent rally. Jim Picerno, The Milwaukee Company’s director of analytics, put it this way in a recent blog post you can find here:


“If the market is pricing in brighter days for next year, the recent trading actions suggest that investors are voting in a new slate of sector leaders. Perhaps, but some analysts advise that it’s premature to discount the bullish momentum in tech because the fundamental driver – earnings growth – remains intact.”


Personally, I don’t get caught up in the value stock vs. growth stock debate. Rather my focus is value investing; that is investing in stocks that appear to be a bargain relative to the market as a whole. By that standard, both growth stocks and value stocks at times can represent a bargain. And who doesn’t like a bargain?


Thank you for reading,


Andrew J. Willms


No recommended reading this week.

[1] The Fama and French three-factor model is used to explain differences in the returns of diversified equity portfolios. Prior to the three-factor model, the Capital Asset Pricing Model (CAPM) identified market risk as the "single factor" to explain portfolio returns.

[2] Value’s outperformance of growth in the 20-year timeframes can be attributed to the bursting of the dot-com bubble in the early 2000’s.

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