Penman – The Value Trap: Value Buys Risky Growth

Abstract:

So-called value stocks earn higher returns than growth stocks on average. However, an investor buying value stocks in hope of those returns may be trapped into buying earnings that are more volatile, more likely to have extreme “tail” outcomes, and are more sensitive to market-wide shocks. These outcomes are demonstrated in a trading strategy that buys stocks based on their earnings-to-price (E/P) and book-to-price (B/P) ratios. Earnings and book values are accounting numbers, so the paper shows how the risk imbedded in E/P and B/P can be attributed to the way that earnings and book values are measured under accounting principles. A striking finding emerges from the analysis: high B/P (“value”) is associated with higher expected earnings growth, but growth that is risky. This contrasts with the standard labeling that nominates low B/P as “growth.”

The Value Trap: Value Buys Risky Growth – Introduction

“Value” and “growth” are prominent labels in the lexicon of finance. They refer to investing styles that buy firms with low multiples (“value”) versus high multiples (“growth”), though the labels sometimes simply refer to buying low price-to-book versus high price-to-book. History tells that value outperforms growth on average, but with risk: a value position can turn against the investor. Indeed the experience with value stocks in the last few years has been sobering. Despite the prominence of these styles, it is not clear what one is buying when one buys value or growth, and the labels are not particularly illuminating. The value investor in particular is anxious that he or she might be caught in a value trap. This paper identifies the risk associated with the higher mean return to value stocks.

There has, of course, been substantial research into the question, largely on how the value-growth return spread is due to exposure to common risk factors. A notable contribution is that of Fama and French (1993) who construct a factor model where the higher returns to high versus low book-to-price are attributed to sensitivity to a “book-to-price risk factor” (along with the market factor and a “size factor”). However, as this book-to-price factor was identified largely from data dredging (to find characteristics that predict returns in the data), there is little understanding of why book-to-price might indicate risk and return. Numerous conjectures abound, many of which have been investigated empirically with some support. But it is fair to say that the “book-to-price effect” in stock returns remains somewhat of a mystery. Of course, higher returns to value may reflect mispricing rather than risk. Even so, it would be worthwhile to understand the risks that one is taking on in pursuing alpha.

This paper explains the value-growth return spread in terms of exposure to the underlying fundamentals. When one buys a stock, one buys future earnings. Accordingly, price multiples imbed expectations of earnings growth; indeed, it is well-recognized that the earnings-to-price (E/P) ratio (or the P/E ratio) imbeds the market’s expectation of future earnings growth. But growth can be risky, subject to shocks, so understanding the exposure to those shocks is the key to understanding the risk in buying value versus growth. The paper shows that, for a given E/P, book-to-price (B/P) indicates the risk in buying earnings growth: A high B/P indicates a higher likelihood that expected earnings growth will not be realized.

Three points emerge. First, E/P and B/P are multiples to be employed together. Just as earnings and book value?the “bottom line” of the income statement and balance sheet respectively?articulate in accounting sense, so do E/P and B/P in an investment strategy: only in applying these multiples together (rather than as individual screens) does the investor understand the risk exposure and the payoffs to that risk. Second, high B/P?a value stock?buys higher earnings growth. This is surprising, for the standard labeling implies that it is “growth” (a low B/P) that buys growth, not “value.” Third, the higher growth associated with value stocks is risky. In particular, high B/P stocks are subject to more extreme shocks to growth: the higher average returns associated with value stocks comes with higher risk.

The paper has a unifying theme: price multiples, like E/P and B/P, are multiples of accounting numbers; given price, they are accounting phenomena. Thus, if these multiples indicate risk, it might have something to do with the how accountants calculate earnings and book value. The paper shows that the returns associated with value versus growth align with an accounting principle for measuring earnings and book value in the presence of risk.

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