Why Growth Stocks are Awesome

Why Growth Stocks are Awesome

August 11, 2011 Research Insights
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(Last Updated On: January 23, 2017)

Sometimes its nice to reflect on some of the more esoteric articles being published in academic finance journals–good way to assess exactly how disconnected from the real-world the ivory tower has become.

The most absurd economic arguments assume humans are perfectly rational computers and not imperfect creatures that sometimes suffer from innate biases.

One of the most studied empirical observations from finance is that value stocks have higher returns than growth stocks. Below is a study I did of the EBIT/TEV factor from 1971-2010 for EBIT/TEV and for a “Shiller P/E-esque” Averge(8YR EBIT)/TEV. As everyone can witness, “value” has better returns than “growth.” Portfolios are value-weighted and the universe is all stocks with a market cap > 10% NYSE benchmark.

5
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

And while everyone agrees that value stocks have had higher returns than growth stocks (a robust finding found in almost every market that has been studied), nobody seems to agree on whether or not value outperforms growth on a risk-adjusted basis.

“Normal” economists and fringe “behavioral” economists disagree on the value anomaly. Normal economists claim that value stocks are inherently riskier, whereas, the “wack-job” behavioral economists claim that value stocks outperform growth because investors are not perfectly rational.

And while this “value anomaly” debate has raged on for years, I was under the impression that Lakonishok, Shleifer, and Vishny (1994) put the argument to bed–behavioral economists finally won an argument. Moreover, out of sample evidence since the classic 1994 paper only reiterates that value does outperform growth, and it is very likely due to investor behavior and not systematic risk (unless of course you thought the internet bubble was rational asset pricing at its finest).

Here are the deciles since 1994:

6
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

So on with the point of this post.

This morning I did some light reading–I looked at an article entitled, “Displacement Risk and Asset Returns,” which is a recent addition to the very prestigious Journal of Financial Economics. The only reason I read the paper is because it was written by one of my former advisors–Stavros Panageas–who is a great guy and really helped me a lot in grad school. That said, you can be a great guy and still come up with some “interesting” ideas.

Here is a link to the paper and the abstract (which doesn’t even cite Lakonishok, Shleifer, and Vishny (1994)):

Displacement Risk and Asset Returns

“We study asset-pricing implications of innovation in a general-equilibrium overlapping-generations economy. Innovation increases the competitive pressure on existing firms and workers, reducing the profits of existing firms and eroding the human capital of older workers. Due to the lack of inter-generational risk sharing, innovation creates asystematic risk factor, which we call “displacement risk.” This risk helps explain several empirical patterns, including the existence of the growth-value factor in returns, the value premium, and the high equity premium. We assess the magnitude of displacement risk using estimates of inter-cohort consumption differences across households and find support for the model.”

So let me synthesize the idea in this paper, and then I’ll let the audience decide if there is a disconnect from reality or not.

First, a set up of the concept:

  1. Value stocks have higher returns than growth stocks (empirical observation).
  2. Rational economic stories require that higher returning assets must have higher systematic risk (we need a story to explain this “anomaly”)
  3. Growth firms have higher innovation levels than value firms (empirical observation)
  4. Because growth firms derive value from future earnings associated with their high innovation, they earn higher valuation ratios (seems reasonable)
  5. Innovation creates a “displacement risk”, in other words, if you’re an old fogey who can’t figure out the latest technology, you’re gonna lose your job (got it.)

And now the conclusion:

  1. Growth firms, which are exposed to “innovation” create an excellent hedge for old fogey’s who can’t get a job when the world moves past them.
  2. So the old fogey’s buy growth stocks as a hedge against losing their jobs. And because growth stocks act as a hedge against losing their jobs, growth stocks rationally earn lower returns than value stocks. QED.

 


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Definitions of common statistics used in our analysis are available here (towards the bottom)




About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray earned a PhD, and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management that delivers affordable active exposures for tax-sensitive investors. Dr. Gray has published four books and a number of academic articles. Wes is a regular contributor to multiple industry outlets, to include the following: Wall Street Journal, Forbes, ETF.com, and the CFA Institute. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.


  • It does sound crazy, but I actually know someone who did this. He even gave me this argument in so many words. One of the stocks he bought was AAPL, so he probably did all right.

  • wes

    He’d be the first person I know that did that.

    Buying AAPL was a nice speculation, but the reality is you’d want to buy a portfolio of these growth stocks (rational theory also says you want to eliminate idiosyncratic risk right?). And if you are buying portfolios of these things, why would you buy a portfolio of growth stocks that gives you lower returns, lower capital preservation (as measured by drawdowns) and performs worse during bad markets? That is insane.

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  • Tal F

    Wes,

    You are absolutely right that Panageas’s idea seems far-fetched at best, and I agree that LSV had more-or-less settled the debate. Having said that, I feel obliged to point out that growth stocks do, generally, do better in a recession. The dot-com 90’s and early 00’s were a notable exception, but if you go back and look at really long histories you will find that in almost every recession (including the ’08-’09 recession) growth stocks have vastly outperformed. Thus the argument, IMHO, for buying growth is not quite displacement risk, but rather the risk of losing your job for any reason in a recession. Basically, growth stocks tend to underperform when you need them most.

    Now, it is still debatable as to whether this outweighs their underperformance over long periods, but ask anyone who has held value stocks over the last 3 years and lost their job whether they are happy with their investment, and you may see why this anomaly has persisted for so long. Value stocks have underperformed growth stocks by about 20% since the start of the crisis, and have continued to underperform during the recent market tumult.

  • Believe it or not, the alleged rational reason for buying growth stocks is the one of the two reasons why I have strategies that short the market, despite the historically poor performance of shorting the market. It’s the way that I can hedge the performance of more illiquid assets such as real estate, education, and vocational knowledge.

    That said, I can count on the fingers of one hand the number of people who hedge their risk in this way, so I hesitate to use this as an explanation for the poor performance of growth stocks.

  • In my question to help people become more rational, I built on the ideas you mentioned here and wrote this:

    http://www.reformedtrader.com/2011/08/trading-as-insurance-policy.html

  • wes

    This certainly seems like a plausible story (and may have some bite to it), but I’m not seeing it in the data I’m looking at. EBIT/TEV (the measure I like for value) seems to hang in there during bear and bull markets, drawdowns are lower, etc. The strategy certainly got rocked in 2008, but has rallied to well surpass SP 500.

    Anyway, I’m not matching the 20% underperformance since the crisis–just eyeballing graph below, HML seems to be about flat since the crisis began.
    Check out image
    http://blog.empiricalfinancellc.com/wp-content/uploads/2011/08/Untitled.png

    Now, if one examines real “value” strategies–ie magic formula type ideas that look at quality & price, and not just price–then there is hardly any debate at all based on data. True value strategies outperform, have lower drawdowns, are less affected by ‘shock events’ and beat growth stocks on just about any metric I can imagine. Who knows. Perhaps the “value” party has ended.

  • Brent Buckner

    The other side of that would have young employees investing in value stocks… would have worked well as a hedge for those folks (especially those in hi-tech) in the late 1990s….

  • Peter Lynch seemed to do OK out of growth stocks.