2006: Value Rules

It has been known since the late 1990s, when Eugene Fama and Kenneth French introduced their three-factor model of portfolio returns, that “value” plays an important role in determining overall portfolio performance. Historically, value stocks have outperformed growth stocks in a significant number of years. Ibbotson Associates, for example, calculated in 2004 that during the previous 35 years large cap stocks outperformed large value stocks on average by 1.6% percent annually.

Still, this phenomenon may be viewed as a paradox. As Burton Malkiel has suggested, investors, being aware that “value” outperforms “growth” should bid up the price of “value” stocks to the level where future returns of “value” and “growth” become practically equal. However, it seems that the effects of the value paradox continued in 2006.

Perhaps the easiest way to illustrate this is to take a look at the performance of six iShares, the Exchange-Traded Funds (ETFs) traded on the New York Stock Exchange. There ETFs, formerly called S&P/Barra, were recently renamed S&P/Citigroup. The six ETFs represent three S&P indices: S&P 500, the largest 500 companies, S&P 400 – the next, medium-sized 400 companies, and S&P 600, the following, by market cap 600 companies, smaller still. Within each group the companies are segregated into two sub-groups using several factors, such as “price to book” (market value to book value), ”cash flow to price”, and others. The higher-priced (relative to their book value), more glamorous stocks are put into the “Growth” category (they also end up having higher P/E ratios, even though P/E is not directly used in selecting these stocks). The rest of the stocks end up in the “Value” category. The names of iShares representing these subgroups are:

Let’s take a look at what happened to these ETFs in 2006. In the table below we have their prices at the beginning and the end of 2006 and price appreciation (return without dividends).

As you can see, even without including the dividends (we’ll address them below), less glamorous value stocks outperformed the growth stocks by a significant margin. S&P 500 value outperformed S&P 500 growth by a whopping 8.69% (18.20% vs. 9.51%) – consider this in view of the S&P’s average historical return of about 12%. Midsize stocks showed the same bias towards value: 12.41% vs. 5.41%. The small value stocks also significantly outperformed the small growth stocks: 17.94% vs. 10.24%.

Furthermore, this is not even the whole story: the growth stocks also tend to pay smaller dividends as they invest their earnings (if there are any) into expanding their business. The table below shows the dividends paid during 2006:

(We calculated Total Dividend using the reinvestment rate equal to the average annual growth rate of the stocks.)

We can see that large value stocks pay almost a whole percentage point higher dividends than the large growth stocks (2.19% vs. 1.27%). Even smaller stocks, which usually pay smaller dividends, differ significantly in this respect: mid cap value stocks pay almost 5 times the dividend rate of the mid-cap growth stocks. The difference between small-cap stocks is even more significant: 1.31% vs. 0.29%.

If we include both the price appreciation and the dividends, the performance advantage of value stocks becomes even more overwhelming:

In each category above, value stocks outperformed large growth stocks by almost 10%. This is quite an amazing disparity.

Whether the same difference will persist in the years to come remains to be seen. It does seem, however, that the “value paradox” endures. Investors may want to keep this in mind during the process of asset allocation.

©2006 Zaks Investment Advisory Service, LLC. All rights reserved.