Value Investing After the Growth Bust and Value Boom

Value Investing after the Growth Bust and Value Ford Foundation's Laurence Siegel Boom tests the accuracy By Laurence B. Siegel of Siegel and

Alexander's earlier n the spring of 2000, growth stocks were booming while value stocks were flagging badly Many long-time value investors were giving up on controversial their strategy, and a number of value-oriented firms were losing assets so rapidly that their existence as business entities was in danger. The prediction of a valuation disparity between growth and value benchmarks had grown value investing so large as to present what appeared to be a once-in-a-lifetime oppor tunity to beat the overall market through value investing. Since the prices of "renaissance" and securities must eventually tend toward their fundamental values, the question was not whether a period of relative outperformance by value stocks would sets forth a vievv occur, but when. Yet forecasters had been pointing this out for some time, and had been early, or wrong; and value investors were continuing to lose money of value versus (to say nothing of trailing broad-market benchmarks) at accelerating rates. In a Joumal oj Investing article, John G. Alexander and I addressed these growth stocks issues. l We started by documenting the historical returns of value and growth stocks, noting that value has had superior long-term returns (although not going forward. clearly so after adjusting for risk). We also showed that the relative valuation of growth and value benchmarks could be examined to provide timing signals. Finally, we constructed lists of representative value and growth stocks and calculated price targets based on fundamental analysis. At the risk of saying "we told you so"-a tone I strain to avoid here-this brief article reviews John Alexanders and my forecasts to see how accurate and timely they were, and sets forth some new forecasts. As most investors are at least vaguely aware, value stocks have delivered their best relative performance in history in the two years since the Joumal oj Investing article (against a backdrop of generally falling market levels). It is now reasonable to ask whether this dramatic price movement has fully corrected the valuation disparity so that growth and value benchmarks are fairly priced relative to one another. I believe that it has not, and that the value cycle still has some distance to run.

© 2002 Investment Management Consultants Association Inc. Reprint with permission only. VOL. 5, NO. 1,]UNEI]ULY 2002 47 RECENT RETURNS ON GROWTH stock portfolios fall in a bear market-it is just a AND VALUE BENCHMARKS matter of how much. But large-cap value stocks rose a little, while small- and mid-cap value xhibit 1 shows the returns on the Russell benchmarks did even better. In addition, many 1000 value and growth benchmarks from "deep value" active managers, who held the most January 1, 1998, through February 28, underpriced stocks, beat their benchmarks. 2002. The chart shows the extraordinary perfor Over the period since March 2000, the return mance of growth relative to value in the first half of spread between value and growth stocks has been the period, then the dramatic reversal in the about what John Alexander and I, relying on fore second half.2 Note that this relative performance casts by Cliff Asness and others at AQR Capital took place in an environment of absolute perfor Management, had anticipated. As of March 2000, mance that was also highly volatile-sharply rising the AQR style timing model (described in greater markets until March 2000, Sideways movement detail later) forecast a 44.8 percent return through September 2000, and then one of the difference between value and growth stocks; the severest bear markets in modern history. The actual difference between the Russeli 1000 Value recovery that started in late September 2001 is and Russell 1000 Growth benchmarks between impressive, but it is too early to tell whether it is March 31,2000, and March 4,2002, was 46.8 per the start of a new bull market 3 cent. 5 With the distortion apparently corrected, Perhaps the most remarkable component of investors should now ask whether value stocks can the last two years' performance is how well value be expected to beat growth stocks going forward. stocks have done in an absolute sense. While the I will get to this later. S&P 500 declined by 23 percent from March 31, 2000, through March 4, 2002, the Russell 1000 RETURNS ON REPRESENTATIVE Value total return index actually made money.4 (It VALUE AND GROWTH STOCKS was up 3.8 percent.) Most investors assume that all ohn Alexander and I constructed two stock lists, one con Exhibit 1: Russell 1000 Value and Growth- taining five representative Total Return Indexes, January 1998-February 2002 growth stocks and the other containing five value stocks, and calculated their fundamental values using a 2.20 .J. I' j CJ) free-cash-flow discount ~ 2.00 ~ .. - -.------...... model for the firm. (Our ~ 1.80 L .._ ------.. free-cash-flow approach "0 was distinguished by using i 1.60 .;. _.- _ .. _. > only public information E o 1.40 for example, IBES earnings ~ growth rate estimates and the exact same model for every stock, whether growth or value. Companies that did not have current positive cash flow were excluded.) We found that the value stocks were underpriced by 21 to

48 THEJOURNAL OF INVESTMENT CONSULTING 48 percent, and that the growth stocks were over The five growth stocks lost, on average, more priced by 60 to 157 percent. We argued that the than two-fifths of their value, about equaling the value stocks were cheap not only relative to the performance of the Russell 1000 Growth growth stocks, but also cheap in an absolute benchmark. We were not trying to beat the growth sense-an important point because the whole benchmark. We were trying to show the danger of market appeared overvalued at the time 6 investing in overpriced stocks, so our list of Exhibit 2 shows our stock lists and their representative growth stocks included some of the subsequent price return through March 4, 2002, most overpriced companies (within the universe of comparing these returns with the performance of those with positive free cash flow). Thus, it is the value and growth benchmarks. The value perhaps a surprise that two of the companies stocks had an average return of 10.4 percent, (Medtronic and KLA-Tencor) fell less than 20 nosing ahead of the Russell 1000 Value bench percent.? mark, despite the collapse of Crown Cork &: Seal, We were constrained somewhat in construct the stock that appeared most undervalued of the ing our stock lists by the desire to avoid either rec five in early 2000. (Dividends, not shown in ommending or "trashing" stocks that were in port exhibit 2, added to the return of the value portfo folios managed by one or both of the organizations lio.) The other four value stocks rose, a couple of in which we worked. Thus the results would have them quite smartly been different, although not necessarily better, if It should not be taken as an indication of our we had had a freer hand in selecting securities. skill that the five-stock value "portfolio" beat its The Crown Cork &: Seal experience teaches a benchmark. We were trying to show the attractive pungent lesson about the risks of value investing. ness of value investing by focusing on a few very When a stock appears cheap, there is always the underpriced companies. Real investors would possibility that it is still way too expensive. A low never construct a portfolio this concentrated. market price can be a bargain-the reflection in an

Exhibit 2: Returns on Representative Value and Growth Stocks

3/20/00 3/4/02 Price price price return

Crown Cork & Seal $16.31 $7.00 -57.1% Dillards $16.13 $21.60 34.0% Mylan $28.25 $30.79 9.0% Sherwin-Williams $21.75 $28.10 29.2% Whirlpool $57.06 $78.09 36.8% Equally weighted average return on value stocks 10.4% Ciena $142.63 $8.71 -93.9% Intuit $54.50 $41.17 -24.5% KLA-Tencor $80.00 $66.63 -16.7% Medtronic $52.69 $45.14 -14.3% Qualcomm $136.25 $38.87 -71.5% Equally weighted aVterage return on growth stocks -44.2%

© 2002 Investment Management Consultants Association Inc. Reprint with permission only. VOL. 5, NO.1, JUNE/JULY 2002 49 inefficient market of investors shunning a compa AQR Style Timing Model ny for no good reason-or it can be the market's The AQR style timing model, on which much savvy assessment that a company is about to crater. of John Alexander):; and my March 2000 forecast This is one good reason why investors seeking relied, begins by looking at the valuation spread, or exposure to value stocks might be well advised to difference between the P-E ratios of growth and hire active managers (at least in addition to, if not value portfolios 8 But fast-growing companies instead of, index funds). should have higher P-Es than slower-growing com panies, so one must next determine whether the WHAT ARE THE PROSPECTS premium one is paying for growth stocks is justi FOR VALUE STOCKS NOW? fied by higher expected growth rates. Thus the model also looks at the growth spread, or difference onstructing another set of value and in expected earnings growth rates between the growth stock lists and calculating their fun growth and value portfolios 9 damental values are unfortunately beyond Exhibit 3 shows the AQR style timing model the scope of this article. (This time, the fine folks graphically When the valuation spread is high but at Invesco were unavailable to perform their the growth spread is also high, that is a neutral sig spreadsheet wizardry, for which I have little talent.) nal regarding value versus growth; growth stocks Instead, I focus on forecasting the returns of aggre are worth a lot and they cost a lot. Likewise, when gates (benchmarks). The tools used to assess the both spreads are low, that is a neutral Signal. A future prospects for value investing are 0) the strong value Signal is given when the valuation AQR style timing model and (2) a look at the long spread is high but the growth spread is low (March term, or eqUilibrium, risk-versus-reward profile of 2000). A strong growth signal is given when the growth and value portfolios as revealed by the his valuation spread is low but the growth spread is torical work of Eugene Fama and Kenneth French. high (December 1997). The strength of the value signal in the spring of 2000 is hard to overstate. Growth stocks were selling Exhibit 3: Valuation and Growth Spreads for about three times the P E of value stocks while January 1982-March 2002 growing only 6 percent a year faster. If one applies our free-cash-flow discount 3.50· Valuation spread 16% model to two groups of ~ (,) stocks, one with earnings ~ 3.001' Q) ! initially growing 6 percent a .2 . '0 ~ 2.50 i " year faster than the other, m~ ! Q...c: i with the growth rates of the (f) ~ 2.00 i 8e ; two portfolios converging :z:; 0> ~o ,.50j over the relatively generous lij", >w period of twenty years, the rL 1 00 . '0 .. I growth portfolio is worth o Growth spread only 1.7 times the value 'iii 0.50;' 2% fS i Source: AQR Capital Management portfolio. Thus growth 0.00 t ,.. ..., - , .. C ,...... ; _-' 0% N M ~ ~ m ~ 00 m a ~ N M ~ ~ w ~ ro m 0 ~ stocks were selling for ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ 9 9 cro ro c cro cro cro cro cm cro cro cro cro cro cro cro cro cm cm cro cro cm almost double what they JJJJJJJJJJJJJJJJJJJJ were worth relative to value stocks. This translated to

50 THE]OURNAL OF INVESTMENT CONSULTING the 44.8 percent relative value-over-growth return do not shun growth portfolios entirely, but hold, forecast referred to earlier. on average over time, an overweighting in value. Is Today, the spreads are quite different. The such a position warranted? valuation spread is above its past average, but by a Not on the basis of the available evidence. much smaller margin than before: it is 0.6 standard Eugene Fama and Kenneth French, who have deviations above its prebubble (1982-1998) backdated value and growth indexes all the way to mean. to In a normal distribution, an observation 1927,13 are famous for (among other things) their 0.6 standard deviations above the mean is at the assertion that the return on an individual stock can seventy-third percentile-a significant but not best be described by a three-factor model, where huge difference from the average. the factors are Moreover, the growth spread has edged • beta, upward, from 6.0 percent in March 2000 to 7.8 • smallness (the difference in returns percent now. This latter observation is still 01 between portfolios of small and large standard deviations below the growth spread's his stocks), torical mean (that is, it would be at the thirty-eighth • valuation (the difference in returns percentile in a normal distribution)ll between portfolios of value-growth The foregoing valuation-spread and growth spread). spread analysis is essentially a proxy for discount Their work is sometimes interpreted as also ing expected cash flows. Using this fundamental predicting that the value index will win in the long (as opposed to technical) approach, one can see run, as it did by a large margin over the historical that investors are still being asked to overpay, a lit period they studied, from July 1927 to January tIe, for growth-and to underpay, a little, for value. 2002. The returns of Fama and French's growth By the way, Asness and his co-authors note and value indexes over this period are shown in that the valuation spread is a better predictor than exhibit 4. 14 A dollar invested in the value portfolio the growth spread. One reason is that P-E ratios are grew to $5,846 over this nearly seventy-five-year measured with relative accuracy (if one helieves the earnings as reported), Exhibit 4: Fama-French Growth and Value Indexes while nobody really knows July 1927-January 2002 what growth rates to expect-they are just ana lysts' forecasts, which are notoriously unreliable. 12 10000 r--- $5,846 " N . Long-Term Returns ~'" 1000 1 ------$1,104 o ' and Risks ~ '0 Fama and French Study * 100 L____ ------ (l) i Setting aside for a c> moment the question of ~ 10 ~-. whether value or growth is currently more attractive, many value managers and some plan sponsors believe 0.1 r--.. ltl (j) (V) r--.. T"" ltl (j) (V) f'.. T"" ltl (j) (V) f'.. T"" LO Ol there is a long-term, or C)l C'J C'J '? "f ' l!l <0 '\' I';- I';- "- c C: C c c C: C: c C: C: c c c C: C: C: '" C: c '"C: eqUilibrium, advantage to ....,::l ...., ::l ...., ::l ...., ::l ....,::l ....,::l ....,::l ....,::l ...., ::l ...., ::l ...., ::l ...., ::l ...., ::l ...., ::l ...., ::l ....,::l ....,::l ...., ::l ...., ::l value investing. Investors who believe this typically

© 2002 Investment Management Consultants Association Inc. Reprint with permission only. VOL 5, NO. 1, JUNE/JULY 2002 51 period, while a dollar invested in the growth port A Peso Problem? folio grew to only $1,104-a rate of return advan In other words, there was a "peso problem" in tage of 2.7 percent per year for value over growth. the value seriesI8 A peso problem is economists' (These results ignore taxes and transaction costs, jargon for a risk that is implicit in the price of an although they include the reinvestment of asset but not evident from its history. The term dividends. No adjustment is made for inflation.) comes from a situation in 1982, when peso Yet after adjusting for risk by calculating the denominated bills (cetes) issued by the Mexican Sharpe ratio, one can see-in exhibit 5-that the Treasury became very popular among yield-seek reward to investors for taking risk was almost ing American investors because their yields were exactly the same for the two portfolios. (The many percentage points higher than U.S. Treasury Sharpe ratio is calculated as the annualized return bills, even though the peso was linked to the dol in excess of the riskless rate, divided by the annu lar and had not experienced a major devaluation in alized standard deviation.) In other words, if decades. The high interest rates appeared to be a investors had leveraged riskless "free lunch" but up the growth portfolio were, in fact, the mar to the risk of the value Exhibit 5: Summary Statistics of Fama ket's forecast of a portfolio, they would French Value and Growth Indexes devaluation. The peso have earned very nearly July 1927-January 2002 was soon devalued, and as much as the value it was the greedy, cetes 15 holding American portfolio did. When Value Growth both portfolios are investors who had the leveraged up or down Compound annual return 12.3% 9.8% peso problem! to the risk level of the Standard deviation 25.7% 19.0% Just as there was no overall market, the Sharpe ratio 0.331 0.318 free lunch in 1982, it value portfolio beats stands to reason that the growth portfolio by one should be suspi only 0.42 percent per cious when it looks like year over the 1927-2002 period. This number is there is a free lunch in any situation. Stated not only tiny but also highly volatile, with the another way, in the long run one asset cannot have growth portfolio winning if one stops at any time a preferred return over another of comparable risk. between June 1999 and November 2000 (instead If there appears to be such a preferred return, it is of in January 2001).16 My conclusion is that the because investors are misunderstanding the risks value premium is just a fair payoff for risk, and that they are taking. on a risk-adjusted basis there is no value premium. The return series for value stocks had a similar, In what sense was the value portfolio more peso-like problem during the 1929-1932 crash. l9 risky7 It fell much more drastically in the Great Over the twenty-seven months from July 1927 to Depression. The value portfolio, loaded up with September 1929 inclusive, the value series had an indebted companies, fell by 90 percent, while the annualized monthly standard deviation of 15.8 higher-quality growth portfolio fell hy "only" 80 percent while the growth series had a standard percent (leaving the growth investor with twice as deviation of 17.3 percent. (If an investor in 1929 much money as the value investor). Value stocks had information from the future, beyond the end also fell more rapidly in the very severe bear of the 1929-1932 crash period, that would not market of 1937-1938; the value index fell 65 per have helped either since value stocks were also less cent while the growth index fell only 46 percent. 17 risky over 1933-2002.) Furthermore, value stocks appeared safer than growth stocks in a fundamental

52 THE]OURNAL OF INVESTMENT CONSULTING sense, since their valuations had not gotten with growth investing, should pervade all security pumped up to the extent that growth stocks were analysis. If you wait long enough, market prices (a situation with parallels in recent history). always tend toward fundamental value. In the first two months of the crash period At least partly because of pressure from con October and November 1929-growth fell by 35.4 sultants and plan sponsors, managers have tended percent, as the growth bubble burst, while value to cluster around "growth" and "value" styles as fell only 16.9 percent. These results presumably defined by popular benchmarks, instead of pursu led investors to conclude that they were right in ing core strategies informed by valuation analysis assessing value stocks as safer. Only as the second, as Buffett's comment might be viewed as suggest third, and fourth waves of the Great Crash unfold ing. Thus value and growth, artificial as they may ed did investors discover that the firm foundations seem to an outside observer, continue to be of their value stocks were infirm. In other words, separate styles with very different returns. there was a risk implicit in the price of the asset Looking forward, value and growth can be (value stocks) that was expected to offer simi not evident from the lar long-term rewards data that were available for taking risk-but at to investors at the time. very different times Some investors will " Value and growth (value and growth will counter that all this is continue to run in ancient history, with lit are indistinguishable. cycles). Sometimes tle relevance for fore Growth is part of the growth stocks are casting. However, value attractive in the sense stocks have always been value equation. " that they are selling for burdened with hnancial Warren Buffett less than their funda and operating leverage mental values. and have tended to be Construed broadly in sunset industries. across the universe of The reasons why markets put low multiples on growth issues, this is not one of those times. While companies tend to be timeless, and include a sound investment policy nearly always includes concerns about risk as well as assessments of lower both styles of investing, a modest overweight to growth rates. Investors can continue to expect value stocks continues to be an attractive posture. greater risk in value stocks-even if the extra risk does not show up in short- or medium-term The author thanks Cliff Asness of AQR Capital standard deviation statistics. Management, New York, for his extensive help.

CONCLUSION Endnotes am not a true believer in value. I cast my vote 1. Laurence B. Siegel and John W Alexander, "The Future of Value Investing," Joumal of Investing (winter with Warren Buffett, who writes, "Value and 2000). On the World Wide Web at http://www.institu growth are indistinguishable. Growth is part of tional.investor.com (click on "Invesco InSights," then the value equation." "Research Summaries," then scroll down to the article In other words, any prudent investor, no mat (downloadable as a PDF). ter how categorized, must do the homework of 2. The performance of growth stocks over this assessing the fundamental value of a stock and period is remarkable even if you do not have a declin comparing that to the stock's price. Such a disci ing set of value stocks to compare it to. Investors pline, currently associated more with value than should have known they were in a bubble.

VOL. 5, NO.1, JUNE/JULY 2002 53 3. Those who define a bull market as a 20 percent 11. It is not necessary to remove bubble-period upward move can declare that a bull market has data from the growth spread, for the purpose of calcu already started. (As of this writing, the S&:P 500 has lating a historical mean, because growth rates were not risen 20 percent from its September 2001 low.) in a bubble-only valuations. However, I would be more cautious than that. A sharp 12. In addition, Asness, Porter, and Stevens (2001) rebound after a long, severe decline should only be find that the value premium is larger for picking stocks considered a new bull market if it incorporates both within industries than for picking industries. (See strong fundamentals (such as earnings growth) and Clifford S. Asness, R. Burt Porter, and Ross L. Stevens, classic bull-market psychology that sets the stage for "Predicting Stock Returns Using Industry-Relative Firm further, sustained increases. Such psychology includes a Characteristics," third draft, AQR Capital Management, desire to buy on dips rather than sell on rallies, a wide New York, April 2001.) In other words, naively ly held perception that stocks are a good long-term applied value techniques tend to identify a few indus investment, and a consensus among quantitative ana tries as underpriced and to build value portfolios that lysts that the forward-looking equity risk premium is are concentrated in those industries. The work of high enough to justify the risks of stocks. Market Asness et al. suggests that a better strategy is to hold psychology is improving but not this much. the industry weights of the market, but in each indus 4. Unfortunately, this positive nominal return did try to hold the stocks that are the most underpriced not exceed the riskless (Treasury bill) rate of interest. using value criteria. 5. The closeness of the forecast and its realization is 13. Eugene F. Fama and Kenneth R. French, purely coincidental. Strictly speaking, the 44.8 percent "Common Risk Factors in the Returns on Stocks and was a one-year forecast, but the realization took place Bonds," Journal of Financial Economics 33 (February over almost two years. Moreover, the forecasts made 1993): 3-56. by Asness et al. are for decile extreme portfolios-the 14. While the original study covered a shorter period, one-tenth of the stocks that are the most "growthy" or the full data set is available on Ken Frenchs website at "value-y" according to a compOSite measure of valua http://mba.tuck.dartmoutho edulpages/facultylken.french! tion that he developed. The benchmarks used by most data_libraryhtml (select "benchmark portfolios investors, and used elsewhere in this paper, are (in monthly") and was used to construct exhibit 4. contrast) much broader. However, the results should 15. For the purpose of this analysis, risk is be similar in direction if not in magnitude. defined as the annualized standard deviation of 6. By using a market-wide equity risk premium of monthly returns. 5 percent over Treasury bonds, a higher number than 16. At least I have verified this for the period from was generally in use at the time, we intentionally July 1927 to June 1999. It should also work for slightly imparted a bearish bias to the whole analysis and earlier and later ending dates. made it more difficult to find stocks that were cheap 17. In fact, the growth index, initialized on in an absolute sense. December 31, 1925, at $1.00, bottomed out in the 7. We were never that bearish on Medtronic; the bear market of 1937-1938 at $1.03. The value Ford Foundation considered it to be a core holding. index plunged as low as $0.48. Almost a decade after We Simply wanted to include one nontechnology stock the Great Crash, then, the growth index was still in the growth list. way ahead. 8. The model is documented in Clifford S. Asness, 18. Jeremy Grantham of Grantham, Mayo, van Jacques A. Friedman, Robert J Krail, and John M. Otterloo &: Co. (Boston) first pointed out the Liew, "Style Timing: Value versus Growth," Joumal of possibility of a Depression-era peso problem in the Portfolio Management 26 (spring 2000): 5-60. value series, long before Fama and French's study 9. In addition, the AQR model contains a made it obvious to anyone looking at the data. momentum component that is not used here. 19. For brevity, we use the terms "value" and 10. It makes sense to take "bubble-era" valuations, "growth" to refer to categories of stocks in the 1920s that is, those starting in 1999, out of the historical and 1930s although these categories were not identi mean for the purpose of making forecasts, unless one fied by those names until some decades later. thinks that the likelihood of entering another bubble is the same as it was historically.