What Is ‘Premium’ In Investing and What Is The Difference Between Value and Growth Stocks?
It’s important to diversify, but when certain slices of the market underperform the rest, it can feel counter-intuitive. Kevin Grogan explains how investors should think about the difference between value and growth stocks.
Hello, Tim Maurer back with another episode of Ask Buckingham, a new video podcast designed to bring clarity in the midst of confusion by connecting your great personal finance questions with straightforward answers from industry thought leaders.
Today’s question will be answered by Kevin Grogan, managing director of investment strategy for Buckingham Wealth Partners. And Kevin, we know it’s important to diversify, but certain slices of the market will underperform the rest of the market for extended periods of time. Value stocks in particular are thought to provide investors with a premium historically, but they have underperformed growth oriented stocks now for several years. Could you please explain what exactly is a premium in investing and what’s the difference between value stocks and growth stocks?
Okay. So a value of premium or any kind of premium is just the difference in return between two types of investments. So what you can think of the value premium is the difference in return between value stocks and growth stocks. The most commonly known premium is something that’s called the equity market premium, which is a difference in return between stocks and riskless treasury bills. These are all examples of premiums that have been researched and discovered in the academic literature over the years.
In terms of the definition of value and growth, the classic definition of value are any stocks that have a low price relative to their book value, the book value of their assets. Whereas a growth stock would be any company or any stock that has a high price relative to its book value. But it’s interesting, at least to geeks like me, that these premiums can be defined multiple different ways and they’ve all worked historically.
So if you said, “Look, we’re going to define value as a low price relative to the earnings,” or “a low price relative to the cashflow,” or “a low price relative to the sales,” or “low price relative to the dividends.” All of these different things work as long as the price is low relative to the fundamental measure. And all of these things have worked historically. But the takeaway from the evidence on the value premium is that what is cheap has tended to be what is expensive historically over the long run.
Well, and that seems to make sense. And by the way, Kevin, we’re really happy that you geek out on this stuff by the way, because it helps us a ton.
Now, okay. Let’s go back to where you started. The equity premium of the stock premium over bonds, most of us don’t question that. If somebody said, “To most people, what has made more money historically, stocks or bonds?” I think most people would probably say stocks. And even in times where stocks are underperforming bonds, we don’t have a tendency to think, “Oh, well, gosh, maybe stocks won’t outperform bonds again in the future.” We just expect that to be there. But right now people are asking the question about value.
Is it possible that this premium is dead? That things have changed so substantially in the marketplace that we won’t see what we have seen historically, which is those underpriced stocks outperforming those overpriced stocks.
And I think the place to start on really both of these, and I think we should talk about both the equity premium and the value premium, is starting with what the evidence was to begin with. So the research on the equity premium goes back to the 1920s in the U.S. And there’s very robust evidence. And I’ll just stay focused on U.S. data for now. That historically stocks have outperformed cash by call it roughly 8% on average, going back to the ’20s. If you look at the value premium, it hasn’t been quite that wide as stocks versus cash, but value stocks have outperformed growth stocks by about 5% on average in the U.S. going back to the 1920s. And those are pretty big numbers.
And the reason why these things have become such bedrocks and in the academic literature is that those are really big numbers to see in the historical data year after year, over time. But the other thing that makes us and makes others in the field so confident that these things will persist for the longterm is that they haven’t just been found in the U.S., that they’ve been found in pretty much every developed market that you look at. No matter where you look, you tend to see that stocks tend to beat cash by about that 8% and value stocks tend to beat growth by about 5%. And it’s not always that exact same number, but it’s in the ballpark. No matter where you look, you see a wide premium for stocks over cash. And you tend to see a pretty big premium for value stocks over growth stocks.
And I think one of the most dangerous things you can ever say is that this time is different. And I think that’s what we’re seeing right now with respect to the value premium. Because it isn’t as if we haven’t seen periods like this before. So the late 1990s are a really good example of a time period where value stocks underperformed growth stocks for a really long time. Where we saw the valuations of the growth stocks getting really stretched, meaning that you started with those stocks having a high price to earnings ratio, but now they’re even higher on that basis looking at price to earnings.
And so we’ve seen periods like this before, but we continue to expect that that value will do better than growth over the longterm. And the other thing I’d mentioned too, is that when people say, “Is value investing dead?” What we’re really talking about is in the U.S. Outside of the US over the past 10 years or so, it’s been closer to a tie as opposed to what we’ve seen in the US with growth stocks, just trouncing value stocks over the past five and 10 years.
So what do you say to the critic who says, “Well, Kevin, listen, man. Things have changed.” I get what you’re saying, but we look at technology companies right now that by the way, do seem to be kind of leading us through some of this challenging time in the COVID-19 crisis. Is it possible that the market will simply continue to reward these innovators in the market more than value companies in the future?
Anything’s possible. So I would be the first just to say that anything’s possible. And really with any of these premiums, you can go very long periods where they don’t work, including the stock premium. So if you were an investor in Japan, starting in the late ’80s, you wouldn’t really see much of an equity market premium over the past 20, 30, 40 years. And so you can go very long stretches of time where these premiums don’t pay off like the way you, you think they will.
But this specific industry question is a really good one. What’s one thing, and again, interesting probably to no one but me about the value premium is that historically it’s worked not just across industries, but within industries. So what I mean by that is the classic definition looks across industries. So basically saying, “Let’s look at all stocks in the U.S. stock market. Let’s just buy the ones that the stocks had had the lowest price to earnings ratio or lowest price to book ratio.”
Another way you could do that is say, “Let’s look at however the market is allocating capital between the various sectors, let’s just look within each sector and buy the lowest price companies within each sector, such that we’re keeping our sector allocation the same as the way the market’s allocated.” If you look at it along that dimension, it’s been equally bad for the value of premium here recently. So it’s not a sector driven thing that’s been happening over the past five and 10 years. It’s been a thing where the high-priced companies have gotten even higher priced than what they were coming into it.
Well, is it an oversimplification than to say that in order to have a reasonable expectation to gather that premium that we expect, that you have to be patient. Premiums require patience.
You have to be very patient and probably more patient than you might expect on the front end. And working with advisors and investors, I think certainly when we say three years isn’t that long. That can be difficult to accept. Or even five years isn’t that long when you’re working with very noisy and volatile data like stock market returns.
And that can be difficult to accept because in every other aspect of our lives, looking at something’s performance or someone’s performance over the past three to five years can tell you a lot. So, as an example, if I’m looking to hire someone for my team, particularly if it’s an internal hire, I’m going to want to know how did they perform in their current position over the past three and five years. And that’ll give me a lot of information about how I might expect that they will perform moving forward.
Or if you don’t use the professional sense, you can kind of go a dating analogy. If you’ve had a relationship with a boyfriend or girlfriend for three years or five years, you have a pretty good indicator of how that’s going to go over the longterm. Unfortunately, with economic data and stock market return data three and five years just isn’t that long of a period of time to draw meaningful conclusions.
Okay. I appreciate the dating analogy in particular. That’s helpful beyond the financial elements of this.
The last question for you, Kevin, it’s been a while for the disciplined value investor that they have been watching this under performance. Is there any evidence to suggest that the longer you wait for a premium to catch up, the greater opportunity there is that we’ll see that premium and reap its benefits in the future?
There is. So this is true again, of all of the premium. So even out to a 20-year horizon, you can find 20-year lengths of time where stocks have underperformed cash. Same thing with the value premium. The longer your horizon, the more likely it is that you’ll see that premium payoff the way you will expect it will.
And so a question that comes up is, “Well, I may not have three, five, and 10 years to wait to see this premium payoff.” Which is totally reasonable response. But the answer or explanation I would give for that is that over every time period, no matter how short, you would expect stocks to do better than cash, you would expect value stocks do better than growth. But instead of being maybe a 90% chance at a 20-year horizon that stocks will be better than cash … if you zoom out, zoom in on one day, one week, or one month, it’s probably a lot or it is a lot closer to 50-50. But the longer you go, the more likely it is that things will work out the way you would expect them to on the front end.
Premiums require patience and perspective. Thank you, Kevin. And thank you for tuning into this episode of Ask Buckingham. If you have a question that you’d like to see us address, you can do so by navigating to the website, askbuckingham.com, by emailing your question to firstname.lastname@example.org, or just click on the screen and it’ll take you directly to the website.
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