Other Theories of Return

A study done by Eugene Fama and Kenneth French (1992) showed that low-risk stocks, namely, value stocks, as measured with high book values relative to their market values, which were expected to perform poorly because of their low expectations, outperformed high-risk stocks over the 27-year period 1963–1990. High-risk or growth stocks with low book values relative to their market values underperformed low-risk stocks over the same 27-year period. The authors classified the stocks into 10 deciles based on their book-to-market ratios. Stocks with the highest book-to-market ratios averaged monthly returns of 1.65 percent, and stocks with the lowest book-to-market ratios averaged monthly returns of only 0.72 percent. This situation is similar to the competition between value and growth stocks. Wall Street analysts expect growth stocks to outperform value stocks, but this study negates that finding.

Looking at the performance of stocks over the three-year period 1996–1998, large-cap growth stocks in the S&P 500 Index outperformed value stocks. Growth stocks had strong records of performance, and stock investors bid them up to high price levels. For example, the stocks of two companies, Dell Computer and Cisco Systems, traded at lofty multiples of earnings, reflecting investor’s high future price expectations. Value stocks have low expectations with regard to return on sales, return on equity, asset growth, equity growth, and book-to-market value. Clayman (1987, p. 58) identified growth stocks and value stocks in 1980 and tracked their performance in the years 1981–1985. She found that the rate of growth and book value fell in half for growth stocks, whereas value stocks showed substantial improvement. If investors had invested $100 in each of the value and growth portfolios, they would have earned $297.50 in the value portfolio versus $181.60 in the growth portfolio for the period 1981–1985.

The Fama and French study provides investors with an alternative to chasing overvalued growth stocks with their lofty multiples, although the jury is still out on the validity of their theory.

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