The CPA Journal

By Nancy L. Beneda

Investment specialists typically advise those who are interested in capital gains and future growth of earnings to invest in growth stocks rather than value stocks. However, a number of studies provide evidence supporting the theory that value stocks, that is, stocks with a low price-to-earnings (P/E) ratio, are more attractive than growth stocks, that is, stocks with a high P/E ratio. A 1998 article in Forbes magazine indicated that value stocks outperform growth stocks by 4%, and carry substantially lower risk as well. In addition, mutual funds that contained value stocks outperformed mutual funds that contained growth stocks in almost all of the cases in the Forbes analysis.

Investors continue to glamorize the profit potential of investing in growth companies, which continue to have high P/E ratios and therefore may be overvalued. This study examines the returns of a group of 100 companies, reported by Fortune magazine to be the fastest-growing companies over the previous three-year period, and examines the investors’ behavior and the performance of these companies from September 4, 2001, to January 18, 2002. The results of the study show that these stocks, on average, underperformed the Standard & Poor’s (S&P) 500 Index by 4.57%.

Literature Review

Besley and Brigham define growth stocks as “stocks of firms that have many positive net present value opportunities.” Growth companies should “exhibit sales and earnings growth rates that significantly exceed the industry averages.” Conversely, a value stock represents a company whose financial position, as well as industry and economic conditions, indicates that its true value is higher than the stock price.

The P/E ratio shows how much value investors have placed on the company’s future growth opportunities. Studies have found that high long-term forecasted growth and high current-earnings growth tend to be associated with higher-than-average P/E ratios. A value-oriented investor prefers to buy stocks whose P/E is below average, and is especially attracted to a stock when the market-average P/E is lower than its historical average.

The P/E ratios of the companies included in this study ranged from 1.88 to 316.21, with a median of 23.72. The average relative P/E ratio (the average P/E divided by the S&P 500’s P/E, multiplied by 100) for the group, as of December 31, 2000, was 124.3 (see Exhibit 1).

Previous studies have indicated that value stocks tend to outperform growth stocks. Lakonishok, Shleifer, and Vishny confirmed that the returns on growth stocks lag behind the return on stocks that have low P/E ratios. Basu found that from April 1957 to March 1971 low P/E portfolios, on average, earned higher rates of return than high P/E portfolios.

In his study of the “nifty fifty,” Siegel analyzed future returns on a portfolio of high-growth stocks in the 1970s. Siegel’s study indicated that these stocks outperformed a market index from the mid-1970s through the end of 1995. The results of Siegel’s study suggest that, over the long term, investing in growth stocks may pay off. His study does not, however, report the return on a comparable portfolio of value stocks.

These studies indicate that, over the short term, value stocks outperform growth stocks. Over the long term, well-selected growth stocks may outperform a market index, but there is no evidence that they will outperform a well-selected group of value stocks. One implication of these studies is that the weighted-average length of time required to receive a growth stock’s expected cash flows may be 20 to 30 years or more. Since the distant cash flows of growth stocks are highly uncertain, small changes in expected earnings growth can cause large changes in the prices of these stocks, increasing risk. A second implication is that investors may be unwilling to hold on to a stock for the time necessary to reap the stock’s benefits.

Data and Methodology

The data set includes the 100 fastest-growing companies reported by Fortune on September 3, 2001. Stock prices (adjusted for stock splits and dividends) for September 4, 2001, and January 18, 2002, were obtained from Yahoo.com for each company in the data set. The beta was computed by Compustat for a five-year period ending on December 31, 2000. Month-end adjusted closing prices (including dividends) were used, and the S&P 500 Index was used as the market index for comparative purposes.

The methodology of this study assumes that an equally weighted portfolio of these stocks is purchased on September 4, 2001. The portfolio return is then computed for the period September 4, 2001, to January 18, 2002, as an average of the returns of the stocks in the portfolio.

Results

Exhibit 1 shows that the average return of the selected stocks over the period was –5.07%. This return is 4.57% below the return on the S&P Index for this time period. This result indicates that investing in growth stocks to achieve short-term capital appreciation may not pay off. The average beta and average relative P/E ratio as of December 31, 2000, were 1.33 and 124.3 respectively, consistent with high-growth companies.

Just as growth stocks can experience alternating periods of undervaluation and overvaluation, growth stocks within industries can experience even larger fluctuations. A strategy of switching from growth to value stocks when P/E ratios become high may yield greater returns than a buy-and-hold strategy. Similarly, a strategy of switching from growth to value stocks within a given industry when P/E ratios within the industry are high may also yield a greater return than a buy-and-hold strategy. For perspective, the average P/E ratio of the S&P 500 since 1935 is about 14.

Average return, average beta, and industry representation within the growth portfolio are reported by industry in Exhibit 2. The two industries with the highest representation in the portfolio were computer devices, parts, peripherals, and software, which accounted for 26.6%, and pharmaceuticals, biological products, drugs, and electro-medical, which accounted for 21.1%. The highest performing group was communication equipment and services (including telephone, radio, and television apparatus), which reported an average return of 19.2% over the test period. The two lowest performing groups were natural resources, with a return of –22.1% (although it should be noted that Enron itself contributed nearly half of this loss), and financial institutions (banks and insurance), with a return of –20.1%.

A Mixed Strategy

Studies generally find that returns on growth stocks often lag behind those of value stocks. These results show that these 100 growth companies underperformed the S&P 500 by 4.57% over September 4, 2001, to January 18, 2002.

This result indicates that investing in growth stocks to achieve short-term capital appreciation may not pay off. A strategy of rotating from growth into value stocks, however, may yield greater returns than a buy-and-hold strategy. Similarly, a strategy of rotating from high P/E companies to low P/E companies within a given industry when P/E ratios within the industry are high, may also improve return.

Nancy L. Beneda, PhD, CPA, is an assistant professor in the Department of Finance at the University of North Dakota at Grand Forks.