Why do value stocks consistently outperform growth stocks in markets around the world?
The debate over what causes this “value premium” has raged in finance circles for decades. One camp, which views markets as efficient, believes the higher returns of value stocks are fair reward for higher economic risk. The other camp, less convinced about the efficiency of markets, argues that growth stocks are systematically overvalued by our bias toward exciting companies with novel products.
New research by Stephan Siegel, an associate professor of finance and business economics at the University of Washington Foster School of Business, suggests the answer is… both.
His novel study offers evidence that support both risk and behavioral explanations of value stocks’ higher average returns by examining investors’ characteristics rather than asset prices.
“Instead of looking at asset prices directly, which is what we do 99 percent of the time in finance,” Siegel says, “we thought, can we look at who invests in these stocks and why?”
Risk and biases
For a personal and long-term view of investors, Siegel and co-authors Henrik Cronqvist (University of Miami) and Frank Yu (CEIBS) analyzed the investment portfolios and biographical details of more than 15,000 pairs of twins logged in the Swedish Twin Registry, the world’s largest such database. These portfolios are available due to Sweden’s national wealth tax, which was discontinued in 2007.
This unique window into a large cross-section of investors revealed characteristics backing both arguments in the debate over the superior returns of value stocks (solid, slow-moving, inexpensive, think Warren Buffet) over growth stocks (exciting, fast-moving, expensive, think T. Rowe Price).
Siegel says that they identified a class of investors who purchase growth stocks as a kind of insurance against negative shocks to their human capital. So, for instance, a journalist concerned that technology threatens her future value buys tech stocks as a hedge against that risk. If there are enough of these investors buying growth as insurance against their own obsolescence, then growth stocks will become expensive today and offer a lower return in the future, while value stocks that do not offer the insurance—but might even be exposed to the same “displacement risk”—will be cheap today and offer higher returns tomorrow.
Thus, the value premium is explained as a function of risk.
But the researchers also found evidence of a class of investors who chase growth stocks due to emotional biases. They buy Apple or Google simply because they’re cool and exciting. This biased buying could contribute to a systematic overpricing of growth stocks and an underpricing of value stocks, leading to higher returns on value stocks relative to growth stocks.
Thus, the value premium is explained as a function of behavioral biases.
Siegel and his colleagues may not have settled the debate. But they’ve certainly offered empirical evidence in support of both explanations.
“Both rational (risk-based) and behavioral explanations seem to be at work in creating the value premium,” Siegel says. “Some investors, indeed, seem to hold growth stocks as insurance. For other investors, whose human capital might be less at risk or who are older and hence have relatively less human capital, value stocks still offer a free lunch, especially to the extent that the higher return is due to behavioral explanations.”
Beyond decoding the enigma of the value premium, Siegel, Cronqvist and Yu went further to understand what makes people fundamentally value or growth investors. What determines our investing “style?”
Again, the Swedish Twin Registry was a trove of insights.
By comparing the difference in financial behavior among the twins, Siegel and his colleagues have been able to identify a significant genetic component behind a number of financial behaviors—including saving, risk taking, real estate ownership and a litany of investing biases.
Investing style proved to be no different.
By comparing the portfolio similarity of identical twins (who share roughly 100 percent of their DNA) versus fraternal twins (who share 50 percent of their DNA, on average), they were able to discern a clear genetic component: as much as 27 percent of the variation in investing style is inherited. To a certain extent, we are born to be growth investors or value investors.
But what about the remaining 73 percent of this variation?
Social psychologists have long pointed to the importance of (early) life experiences that shape an individual’s beliefs and behaviors.
Thinking about the different childhood environments of Benjamin Graham, the father of value investing, and T. Rowe Price, the father of growth investing, Siegel, Cronqvist, and Yu wondered if there was a link.
Graham grew up very poor, his father passing away unexpectedly when he was young and his mother losing the family’s savings in a stock market crash in 1907. Among his brothers, Graham was often tasked with “bargain hunting” at different grocery stores. By comparison, Price had a privileged upbringing, his father a medical doctor who served as a surgeon for a rapidly expanding railroad company, in a growth industry of its time.
Do such differences in early economic experiences contribute to differences in investment style later in life?
“Our findings suggest that the harsher the economic experience during your younger days, the more cautious you tend to be as an investor,” Siegel says. “And the more favorable the economic experience, the more growth-oriented you tend to be. To some extent, we come to believe in value or growth.”
This belief comes from both microeconomic and macroeconomic experience.
On the micro side, there’s a correlation between family income and investing style. Rich kids tend to grow up with a greater tendency to seek growth stocks and poor kids tend to seek value.
On the macro side, people who experience robust GDP growth, especially early in their careers, tend to become growth investors. And people who experience weak GDP growth (such as during the Great Depression), especially during their young adulthood, tend toward the stability of value over the volatility of growth.
“Value versus Growth Investing: Why Do Different Investors Have Different Styles?” was published in the August 2015 Journal of Financial Economics.