February 19 , 2003

The academic authors thought they had uncovered a device to test whether stock markets are efficient.  Instead, they may have uncovered insights into the abuses of stock analysts during our recent investment bubble. 

Investment advisors use several categories to determine the behavior of equities.  Stocks that show substantial sales and earnings growth over time are classified as growth stocks (even if they stumble for short periods of time).  Stocks that have low stock prices relative to book value are classified as value stocks. 

Since 1927, value stocks have outperformed growth stocks by an annual rate of 3.7 percent a year.  We will assume that the difference is not caused by measurement errors (always an issue in an academic study). 

However, if markets rapidly absorb all new information and have it reflected in stock values very soon after it is known (the efficient market theory), then one class of stocks should not consistently outperform another class of stock if they have the same characteristics. 

Some finance professors have argued that the fact that value stocks outperform growth stocks reflects the greater risk of value stocks.  For example, some so called value stocks may be losing price because investors realize that capital is being used poorly in that company.  Indeed, the appearance of value may be nothing more than a snapshot on the road to bankruptcy for some companies. 

Thus, the value stocks show better price gains over time because they are riskier according to those professors.  Risk is an undesirable trait that requires higher compensation to prevent investors from fleeing those stocks.

There is no easy way to determine what risk investors believe exist in any stocks.   However, if a market already has incorporated all known information into its prices, then forecasts of superior performance must mean expectations of currently unknown outcomes.  Thus, forecasts of better stock price performance imply that more risk exists in those issues.

As I believe markets have too much emotion to perform efficiently in the short run, I am not as willing to make the assumption that forecasts of stronger price performance must mean more risk.  They may merely intensify the confidence in the management of resources. 

Professors Alon Brav of Duke, Roni Michaely of Cornell, and Reuven Lehavy of the University of Michigan used two different groups of forecasts to evaluate whether the risks implied in forecasts of future pricing suggested that value stocks were riskier than growth stocks.  In neither case did they make a scientific sample of all investors. 

Instead, they used the forecasts of analysts in the Thomson First Call database from 1997 through 2001 for one measure.  They then used Value Line price projections over a 15 year period from 1987 to 2001. 

In the first study, projections of growth stock performance far outdistanced value stock forecasts.  The latter study showed little change between the two.  In neither case did analysts expect value stocks to outperform growth stocks.  (Remember, the fact is that value stocks do outperform.  Therefore, the price difference is not caused by inherent risks between the two classes of stocks.)

The study concluded that as value stocks as a group were no riskier than growth stocks but they outperformed growth stocks over long periods of time, value stocks may be bargains. 

Frankly, I believe the study shows that we normally choose the hare and are shocked when the slow and steady tortoise wins.  Instead of reflecting all known information, the stock market reflects human emotions in the short run.  (I am willing to assume the markets are efficient in the long run, but that is another column). 

However, the study suggests something else as well.  The authors believed that stock analysts might have been biased in their forecasts because they were rewarded by equity banking business, which flows more rapidly from growth stocks.  That is why they not only used First Call but also sought out Value Line. 

The latter analysis is provided on a subscription basis and is not subject to bias by banking business.  Over their time frame, the First Call analysts projected that strong growth stocks would outperform high rated value stocks by more than 20 percentage points per year.  No similar discrepancy was observed for the possibly unbiased analysts of Value Line. 

This is not a definitive conclusion that banking business biased analyst opinions, for the analysis was not done over comparable time periods.  However, it strongly suggests that banking business might have distorted the work of analysts in houses doing banking business during the formation of the stock market bubble. 

In the meantime, do not shun value stocks because past performance might suggest that they are more risky than the growth stocks.  Current studies suggest that any presumed higher risk is not justified. 



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