Value Versus Growth When the Economy Is Bad

Does value beat growth because: (1) investors/traders irrationally overreact to recent bad (good) news about value (growth) stocks; or, (2) they rationally recognize that value stocks are inherently more risky than growth stocks? In their March 2005 paper entitled “Value versus Growth: Movements in Economic Fundamentals”, Yuhang Xing and Lu Zhang seek to clarify the value-growth contest by examining how the fundamentals (earnings growth, dividend growth, sales growth, investment growth, profitability and investment rate) of value and growth companies behave during different parts of the business cycle. Using two samples for manufacturing companies for 1963-2002 and 1928-2002 and defining “value” (“growth”) as the top (bottom) 20% in book-value-to-market capitalization, they find that:

• Value stocks outperform growth stocks by 0.55% per month on a value-weighted basis and 1.11% per month on an equal-weighted basis.
• On average, growth companies have higher rates of growth for earnings, net income, dividends, sales and investment than do value companies.
• The fundamentals of value companies react more adversely and sharply to negative business cycle shocks than do those of growth companies. (See the figure below for earnings growth as an example.)
• Lack of flexibility in capital investment (an inability to respond to negative shocks) may cause this more cyclical behavior of value companies.

The following chart, one of many in the paper, shows the average behavior of earnings growth for value companies (solid line) and growth companies (dashed line) during periods of economic expansion (white areas) and contraction (shaded areas). It shows the relatively sharp declines in earnings growth for the average value company during bad economic times.

In summary, value beats growth as a rational reward for the relatively higher risk inherent in the fundamental performance of value companies during recessions.

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