1926 through December 2006 (Including and Excluding 1975–1983)
1983 is eliminated, the total accumulation in large stocks over the entireperiod from 1926 through 2006 is virtually the same.After 1983, small stocks hit a long dry period that lasted 17 years asthey underperformed large stocks, especially in the late 1990s as thetechnology boom gained momentum. But when the technology bubbleburst, small stocks strongly outperformed once again. From the March2000 peak through 2006, despite the severe intervening bear market,small stocks enjoyed a 7.2 percent annual return, while large stocks, represented by the S&P 500 Index, returned less than 1 percent per year.What caused the tremendous performance of small stocks during the1975 to 1983 and 2000 to 2006 periods? In the earlier period, pension andinstitutional managers found themselves attracted to smaller stocks following the collapse of the large-growth stocks, known as the “Nifty Fifty,”that were so popular in the preceding bull market. In addition, the enactment of the Employee Retirement Income Security Act (ERISA) by Congress in 1974 made it far easier for pension funds to diversify into small
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stocks, boosting their holdings of these issues. The 2000 to 2006 smallstock surge followed the collapse of large-cap tech stocks in the bubble ofthe late 1990s, which again turned investors’ attention to smaller issues.Whatever the reasons for the small stock surges, the trendiness ofsmall stock returns does not mean that investors should avoid thesefirms. Small- and mid-cap stocks not in a big capitalization index such asthe S&P 500 Index constitute about 20 percent of the market value of allU.S. stocks. One should be warned, however, that the existence of thesmall stock premium does not mean that small stocks will outperformlarge stocks every year, or even every decade.
VALUATIONValue Stocks Offer Higher Returns Than Growth StocksThe second dimension along which stocks are classified is by valuation—that is, factors relating the price of the stock relative to some fundamental metric of firm worth, such as dividends, earnings, book values, andcash flows. Like small-cap stocks, Fama and French determined thatstocks that were cheap relative to these fundamentals had higher returnsthan would be predicted by the capital asset pricing model.Stocks whose prices are low relative to these fundamentals arecalled value stocks, while those with prices high relative to these fundamentals are called growth stocks. Prior to the 1980s, value stocks wereoften called cyclical stocks because low-P-E stocks were often found inthose industries whose profits were closely tied to the business cycle.With the growth of style investing, equity managers that specializedin these stocks were uncomfortable with the “cyclical” moniker andgreatly preferred the term “value.”Value stocks generally occur in such industries as oil, motor, finance, and utilities where investors have low expectations of futuregrowth or believe that profits are strongly tied to the business cycle,while growth stocks are generally found in such industries as high technology, brand-name consumer products, and healthcare where investorsexpect profits either to grow quickly or to be more resistant to the business cycle.Of the 10 largest U.S.-based corporations by market value at theend of 2006, Exxon Mobil, Citigroup, and Bank of America had a lowprice relative to fundamentals and were considered “value stocks” whileMicrosoft, Procter & Gamble, and Johnson & Johnson had higher prices,consistent with “growth stocks.”
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Although value stocks might sound unattractive, these stocksshould not be shunned by investors. First, investors’ expectations of lowgrowth may be incorrect. But, more importantly, even if these expectations are correct, these stocks might offer superior returns if their price islow enough to compensate for the lower growth. In fact, as we shallshow below, value stocks generally give investors higher returns thangrowth stocks.
DIVIDEND YIELDSDividends have always been an important criterion for choosing stocksas Graham and Dodd stated in 1940:Experience would confirm the established verdict of the stock marketthat a dollar of earnings is worth more to the stockholder if paid him individends than when carried to surplus. The common-stock investorshould ordinarily require both an adequate earning power and an adequate dividend.10
Graham and Dodd’s claim has been supported by more recent research. In 1978, Krishna Ramaswamy and Robert Litzenberger established a significant correlation between dividend yield and subsequentreturns.11 And more recently, James O’Shaughnessy has shown that inthe period 1951 through 1994, the 50 highest-dividend-yielding largecapitalization stocks had a 1.7 percentage point higher return than themarket.12The historical analysis of the S&P 500 Index supports the case forusing dividend yields to obtain higher stock returns. Using December 31of each year from 1957 onward, I sorted the firms in the S&P 500 Indexinto five groups (or quintiles) ranked from the highest to the lowest dividend yields, and then I calculated the total returns over the next calendar year.The striking results are shown in Figure 9-2. In strictly increasingorder, the portfolios with higher dividend yields offered investorshigher total returns than portfolios of stocks with lower dividend yields.If an investor put $1,000 in an S&P 500 Index fund at the end of Decem10
Graham and Dodd, Security Analysis, 2d ed., p. 381.See Robert Litzenberger and Krishna Ramaswamy, “The Effects of Personal Taxes and Dividendson Capital Asset Prices: Theory and Empirical Evidence,” Journal of Financial Economics, 1979, pp.163–195.12James P. O’Shaughnessy, What Works on Wall Street, 3rd ed., New York: McGraw-Hill, 2003.11
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FIGURE
9–2
Historical Analysis of the S&P 500 Index, 1957 to 2006
ber 1957, she would have accumulated $176,134 by the end of 2006, foran annual return of 11.13 percent. An identical investment in the 100highest dividend yielders accumulated to over $675,000, with a return of14.22 percent.The highest dividend yielders also had a beta below unity, indicating these stocks were more stable over market cycles, as shown in Table9-2. The lowest-dividend-yielding stocks not only had the lowest returnbut also the highest beta. The annual return of the 100 highest dividendyielders in the S&P 500 Index over the past 50 years was 3.78 percentagepoints per year above what would have been predicted by the efficientmarkets model while the return of the 100 lowest dividend yielderswould have had a return that was 1.68 percentage points per yearlower.
CHAPTER 9 Outperforming the Market
TABLE
147
9–2
S&P 500 Stocks Sorted by Dividend YieldDividendYield
GeometricReturn
ArithmeticReturn
StandardDeviation
Beta
Excess Returnover CAPM
HighestHighMiddleLowLowestS&P 500
14.22%13.11%10.55%9.79%9.69%11.13%
15.71%14.24%11.71%11.35%12.20%12.39%
18.81%16.22%16.02%18.21%23.17%16.52%
0.93360.85590.90851.04601.21301.0000
3.78%2.86%-0.04%-1.36%-1.68%0.00%
Other Dividend Yield StrategiesThere are other high-dividend-yield strategies that have outperformedthe market. A well-known one is called the “Dogs of the Dow,” or the“Dow 10” strategy, and is chosen from high-yielding stocks in the DowJones Industrial Average.The Dow 10 strategy has been regarded by some as one of the simplest and most successful investment strategies of all time. James Glassman of the Washington Post claimed that John Slatter, a Clevelandinvestment advisor and writer, invented the Dow 10 system in the1980s.13 Harvey Knowles and Damon Petty popularized the strategy intheir book The Dividend Investor, written in 1992, as did Michael O’Higgins and John Downes in Beating the Dow.The strategy calls for investors at year-end to buy the 10 highestyielding stocks in the Dow Jones Industrial Average and to hold themfor the subsequent year and then repeat the process each December 31.These high-yielding stocks are often those that have fallen in price andare out of favor with investors. For this reason the Dow 10 strategy isoften called the “Dogs of the Dow.”Another natural extension of the Dow 10 strategy is to choose the10 highest-yielding stocks from among the 100 largest stocks in the S&P500. The 100 largest stocks in the S&P 500 Index comprise a much higherpercentage of the entire U.S. market than the 30 stocks in the Dow JonesIndustrial Average.13
John R. Dorfman, “Study of Industrial Averages Finds Stocks with High Dividends Are Big Winners,” Wall Street Journal, August 11, 1988, p. C2.
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Indeed, both of these strategies have excelled, as Figure 9-3 shows.14The Dow 10 strategy returned 14.08 percent per year over the past halfcentury, and the S&P 10 returned a dramatic 15.71 percent per year, morethan 3 and 41⁄2 percentage points a year above their respective benchmarks. And both these strategies have a lower beta than either the DowJones Industrial Average or the S&P 500 Index, as shown in Table 9-3.The worst year for both the Dow 10 and S&P 10 strategies relativeto the benchmark indexes was 1999, when the high-capitalization techstocks reached their bubble peak. The Dow 10 underperformed the S&P500 Index by 16.72 percent that year, and the S&P 10 underperformed byover 17 percentage points. It is during the later stages of a bull market,14
Interestingly, an equal investment in the 30 Dow Jones Industrial stocks beats the performance ofthe S&P 500 Index from 1957 through 2006 by 73 basis points even though the Dow’s beta is lessthan 1. The managing editor of the Wall Street Journal has the primary responsibility for the selectionof the Dow stocks. As noted in Chapter 4, the companies in the S&P 500 Index are chosen primarilyon the basis of market value, assuming that the firm is profitable.
FIGURE
9–3
Dow and S&P 500 High-Dividend Yield Strategies
CHAPTER 9 Outperforming the Market
TABLE
149
9–3
Dow and S&P 500 High-Dividend Strategies
when growth stocks catch the eye of speculative investors, that thesevalue-based strategies will underperform capitalization-weightedstrategies.But these strategies have gained these back—and more—duringsubsequent bear markets. The Dow 30 was down by 26.5 percent, andthe S&P 500 Index was down 37.3 percent during the 1973 to 1974 bearmarkets. But the S&P 10 strategy fell only 12 percent while the Dow 10strategy actually gained 2.9 percent in these two years.These dividend strategies also resisted the 2000 to 2002 bear market. From the end of 2000 through the end of 2002, when the S&P 500Index fell by more than 30 percent, the Dow 10 strategy fell by only lessthan 10 percent, and the S&P 10 strategy fell by less than 5 percent.15These high-dividend strategies have provided investors with higher returns and lower volatility over the past five decades.
PRICE-TO-EARNINGS (P-E) RATIOSAnother important metric of value that can be used to formulate a winning strategy is the P-E ratio, or the price of a stock relative to its earnings. The research into P-E ratios began in the late 1970s, when SanjoyBasu, building on the work of S. F. Nicholson in 1960, discovered thatstocks with low price-to-earnings ratios have significantly higher returns than stocks with high price-to-earnings ratios, even after accounting for risk.1615
After 2003 the Dow 10 strategy lagged the Dow 30 for several years, mostly because of the poorperformance of General Motors, which continued to pay a dividend until it was cut in half in 2005.16S. F. Nicholson, “Price-Earnings Ratios,” Financial Analysts Journal, July/August 1960, pp. 43–50,and Sanjoy Basu, “Investment Performance of Common Stocks in Relation to Their Price-EarningsRatio: A Test of the Efficient Market Hypothesis,” Journal of Finance, vol. 32 (June 1977), pp. 663–682.
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Again, these results would not have surprised the value investorsGraham and Dodd, who, in their classic 1934 text Security Analysis,stated the following:Hence we may submit, as a corollary of no small practical importance, thatpeople who habitually purchase common stocks at more than about 16times their average earnings are likely to lose considerable money in thelong run.17,18
In a manner analogous to the research on dividend yields amongS&P 500 stocks, I computed the P-E ratios for all 500 firms in the indexon December 31 of each year by dividing the last 12 months of earningsby the year-end prices. I then ranked these firms by P-E ratios and divided them into five quintiles, computing their subsequent return overthe next 12 months.19The results of this research are similar to that reported on the dividend yield and are shown in Figure 9-4. Stocks with high P-Es (or lowearnings yields) are, on average, overvalued and have given lower returns to investors. A portfolio of the highest-P-E stocks had a cumulativereturn of $65,354, earning an annual return of 8.90 percent, while thelowest-P-E stocks had a return of 14.30 percent and accumulated to almost $700,000.In addition to a higher yield, the standard deviation of low-P-Estocks was lower, and the beta was much lower than that of the S&P 500Index stocks, as shown in Table 9-4. In fact, the return on the 100 lowestP-E stocks in the S&P 500 Index was about 51⁄2 percentage points per yearabove what would have been predicted on the basis of the capital assetpricing model.
PRICE-TO-BOOK RATIOSPrice-to-earnings ratios and dividend yields are not the only valuebased criteria. A number of academic papers, beginning with DennisStattman’s in 1980 and later supported by Fama and French, suggested1718
Graham and Dodd, Security Analysis, 1st ed., p. 453. Emphasis theirs.
Yet even Graham and Dodd must have felt a need to be flexible on the issue of what constitutedan “excessive” P-E ratio. In their second edition, published in 1940, the same sentence appears withthe number 20 substituted for 16 as the upper limit of a reasonable P-E ratio! (Graham and Dodd,Security Analysis, 2d ed., p. 533.)19Firms with zero or negative earnings were put into the high-P-E-ratio quintile. Returns were calculated from February 1 to February 1 so that investors could use actual instead of projected earnings for the fourth quarter.
CHAPTER 9 Outperforming the Market
FIGURE
151
9–4
P-E Ratios for the S&P 500 Index Companies, 1957 through December 2006
TABLE
9–4
Returns on the S&P 500 Stocks Sorted by P-E RatiosP-E Ratio
GeometricReturn
ArithmeticReturn
StandardDeviation
Beta
Excess Returnover CAPM
LowestLowMiddleHighHighestS&P 500
14.30%13.52%11.11%10.04%8.90%11.13%
15.35%13.52%11.11%10.04%8.90%12.39%
15.50%15.79%14.59%14.95%18.84%16.52%
0.63470.60670.62300.70770.85461.0000
5.51%4.99%2.30%0.70%-0.78%0.00%
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that price-to-book ratios might be even more important than price-toearnings ratios in predicting future cross-sectional stock returns.20Like P-E ratios and dividend yields, Graham and Dodd consideredbook value to be an important factor in determining returns:[We] suggest rather forcibly that the book value deserves at least a fleetingglance by the public before it buys or sells shares in a business undertaking. . . . Let the stock buyer, if he lays any claim to intelligence, at least beable to tell himself, first, how much he is actually paying for the business,and secondly, what he is actually getting for his money in terms of tangible resources.21
Although Fama and French found that the ratio of book to marketvalue was a slightly better value metric than the dividend yield or P-Eratio in explaining cross-sectional returns in their 1992 research, thereare conceptual problems with using book value as a value criterion.Book value does not correct for changes in the market value of assets,nor does it capitalize research and development (R&D) expenditures.In fact, over the time period 1987 through 2006, our studies showedthat book value underperformed either dividend yields, P-E ratios, orcash flows in explaining returns.22 Since it is likely that an increasingfraction of a firm’s worth will be captured by intellectual property,book value may become an even more imperfect indicator of firmvalue in the future.
COMBINING SIZE AND VALUATION CRITERIAThe compound annual returns on stocks sorted into 25 quintiles alongsize and book-to-market ratios from 1958 through 2006 are summarizedin Table 9-5.23 Historical returns on value stocks have surpassed growthstocks, and this outperformance is especially true among smaller stocks.The smallest value stocks returned 19.59 percent per year, the highest ofany of the 25 quintiles analyzed, while the smallest growth stocks returned only 5.97 percent, the lowest of any quintile. As firms becomelarger, the difference between the returns on value and growth stocks be20Dennis Stattman, “Book Values and Expected Stock Returns,” unpublished MBA honors paper,University of Chicago, and Fama and French, “Cross Section of Expected Stock Returns.”21Graham and Dodd, Security Analysis, 1st ed., pp. 493–494.22Unpublished work estimating the alpha from quintile selection of value strategies from 1987through 2006 using the data on the Fama-French Web site http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html.23These data come from the Fama-French Web site cited in the preceding footnote.
CHAPTER 9 Outperforming the Market
TABLE
153
9–5
Compound Annual Returns by Size and Book-to-Market Ratio, January 1, 1958, to December 31, 2006
Book-to-MarketQuintiles
Entire Period
Size QuintilesSmall
2
3
4
Large
Value
19.59%
18.29%
17.58%
16.10%
13.17%
2
18.37%
17.53%
16.20%
16.15%
12.25%
3
15.06%
16.00%
13.90%
14.72%
12.16%
4
13.90%
12.78%
13.92%
11.43%
11.11%
Growth
5.97%
8.30%
8.85%
10.62%
9.87%
Excluding
Book-to-MarketQuintiles
1975-1983
Size QuintilesSmall
2
3
4
Large
Value
15.52%
14.86%
14.64%
13.67%
12.04%
2
14.80%
13.98%
13.49%
14.50%
10.69%
3
10.91%
13.23%
10.92%
12.43%
11.18%
4
9.61%
9.11%
10.75%
9.26%
9.94%
Growth
1.46%
4.62%
5.91%
8.73%
9.56%
comes much smaller. The largest value stocks returned 13.17 percent peryear while the largest growth stocks returned about 9.87 percent.When the 1975 to 1983 period is removed, the return to small stocksshrinks, as expected. But it is noteworthy that the difference in the returnsto small value and growth stocks remains large and virtually unchanged.The dramatic difference in the cumulative return to smallest quintile growth and value stocks over the period from 1957 through 2006 areshown in Figure 9-5. Small growth stocks have a cumulative return ofonly 5.97 percent per year over the period, and $1,000 invested in December 1957 accumulated to $17,121 by the end of 2006. In contrast,small value stocks have a cumulative return of 19.59 percent per year,and a $1,000 investment grows to $6.42 million.Accentuating the difference in the performance of small growthand value stocks is that the risk measured by the beta of the small-capvalue stocks is about 1, while that of the small growth stocks is over 11⁄2.
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FIGURE
9–5
Cumulative Returns to Smallest Quintile Growth and Value Stocks, 1957 through December 2006
This means that the historical return to small value stocks is nearly 10percentage points above the “efficient market” prediction, while the historical return to small growth stocks has been 4.4 percentage pointsbelow its predicted level.
INITIAL PUBLIC OFFERINGS: THE DISAPPOINTING OVERALLRETURNS ON NEW SMALL-CAP GROWTH COMPANIESSome of the most hotly sought after small stocks are initial public offerings (IPOs).New companies are launched with enthusiasm that excites investors, who dream that the upstarts will turn into the next Microsoftsor Intels. The large demand for IPOs causes most IPOs to surge in priceafter they are released into the secondary market, offering those investors who were able to buy the stock at the offering prices immedi-
CHAPTER 9 Outperforming the Market
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ate gains.24 As a result, the vast majority of these IPOs are classified as“growth” stocks.Certainly there have been some big winners among past IPOs. WalMart, which went public in October 1970, turned a $1,000 investmentinto more than $1,370,000 by the end of 2006. Investors who put $1,000into Home Depot and Intel when they went public also turned into millionaires—if they held on to their stock. Cisco Systems was another winner. Floated to the public in February 1990, the networking supplier hasdelivered an average of 40 percent annual returns to investors throughDecember 2006, although all of the gains were made in the first 10 years.But can these big winners compensate for all the losers? To determine whether IPOs are good long-term investments, I examined the buyand-hold returns of almost 9,000 IPOs issued between 1968 and 2001. Icalculated the returns whether investors purchased the IPOs either at theend of the first month of trading or at the IPO offer price and held thesestocks until December 31, 2003.25There is no question that the losing IPOs far outnumber the winners. Of the 8,606 firms examined, the returns on 6,796 of these firms, or79 percent, have subsequently underperformed the returns on a representative small stock index, and almost half the firms have underperformed by more than 10 percent per year.Unfortunately, the huge winners like Cisco and Wal-Mart cannotcompensate for the thousands of losing IPOs. The differences in the returnsto a portfolio that buys an equal dollar amount of all the IPOs issued ina given year and a portfolio in which an investor puts an equivalent dollar amount into a Russell 2000 small-cap stock index are featured in Figure 9-6. Returns are computed from two starting points: (1) from the endof the month when the IPO was first issued and (2) from the usuallylower IPO offer price.The returns on all yearly IPO portfolios issued from 1968 through2000 were examined to December 31, 2003, to allow for at least threeyears of subsequent returns to be calculated. The results are clear. From1968 through 2000, the yearly IPO portfolios, measured from the end ofthe price of the first month of trading, underperformed a small-cap stockindex in 29 out of 33 years when measured either from the last day oftrading in the month they were issued or from the IPO issue price.24Obtaining IPOs at the offering prices, especially ones that are in great demand, is very difficult asinvestment banks and brokerage firms ration these shares to their best customers.25About one-third of these firms survived in their current corporate form through December 31,2003. If they did not, I substituted the return on the Ibbotson small-cap stock index (see footnote 9).
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FIGURE
9–6
Buy-and-Hold Returns of Almost 9,000 IPOs Issued between 1968 and 2001
Even in years such as 1971 when the big-winning stocks SouthwestAirlines, Intel, and The Limited Stores all went public, a portfolio of allthe IPOs issued that year trailed the returns on a comparable small-capstock index when measured through 2003, and the same happened in1981 when Home Depot went public.Even in the banner year 1986, when Microsoft, Oracle, Adobe,EMC, and Sun Microsystems all went public and delivered 30 percentplus annual returns over the next 16 years, a portfolio of all the IPOsfrom that year just barely managed to keep up with the small-cap stockindex.The performance of the mostly technology IPOs issued in the late1990s were disastrous. The yearly IPO portfolios in 1999 and 2000 underperformed the small-cap stock index by 8 and 12 percent per year, respectively, if measured from the IPO price and 17 and 19 percent peryear if measured from the end of the first month of trading.Even stocks that doubled or more on the opening of trading werevery poor long-term investments. Corvis Corporation, which designs
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products for the management of Internet traffic, went public on July 28,2000. At the time of the offering, the firm had never sold a dollar’s worthof goods and had $72 million in operating losses. Nevertheless, Corvishad a market value of $28.7 billion at the end of the first trading day, acapitalization that would place it in the top 100 most valuable firms inthe United States.It is sobering to contrast Corvis Corporation with Cisco Systems,which went public 10 years earlier. By the time of its IPO in February1990, Cisco had already been a profitable company, earning healthyprofits of $13.9 million on annual sales of $69.7 million. The marketvalue of Cisco’s IPO at the end of the first trading day was $287 million,exactly one-hundredth of the market value of Corvis Corporation,which at the time had not yet had either sales or profits. Cisco would beclassified as a “growth” company in 1990 with a higher-than-averageP-E ratio, but Corvis was a “hypergrowth” company.Corvis Corporation, with an IPO price of $360 (split adjusted) onJuly 28, 2000, opened trading at $720 and later rose to $1,147 in early August. Subsequently the stock fell to $3.46 in April 2005.
THE NATURE OF GROWTH AND VALUE STOCKSWhen choosing “growth” and “value” stocks, investors should keep inmind that these designations are not inherent in the product the firmproduces or the industry that the firm is in. The designations dependsolely on the market value relative to some fundamental measure of enterprise value, such as earnings or dividends.Therefore, a firm in the technology sector, which is considered to bean industry with high growth prospects, could actually be classified as avalue stock if it is out of favor with investors and sells for a low price relative to fundamentals. Alternatively, a promising auto manufacturer in amature industry with limited growth potential could be classified agrowth stock if its stock is in favor with investors and priced