Why We Value "Value" - April 30, 2004
Although a number of mutual fund data services categorize the Perritt MicroCap Opportunities Fund as a "blend" fund (i.e., its portfolio consists of both growth stocks and value stocks), the Fund's portfolio managers have always favored value stocks over growth stocks. Of course, like beauty, value is often in the eyes of the beholder. Thus, you will frequently find a number of stocks residing in the portfolios of both growth investors and value investors.
However, there are marked differences between growth and value stocks. Generally, growth stocks are those of companies that have experienced or are expected to experience double-digit percentage annual growth in revenues, earnings and assets. These companies earn high returns on equity and often sell at lofty multiples of revenues, earnings and book values. On the other hand, value stocks sport more modest annual growth rates, have lower debt ratios, and often pay cash dividends. The stocks of these companies frequently sell at below market multiples of revenues, earnings and book values.
While I could cite several reasons why I favor value stocks over growth stocks, the most compelling is that when it comes to long-run investment returns, portfolios of value stocks handily beat portfolios of growth stocks. Here is a bit of the historical record.
In the latest edition of the Stocks, Bonds, Bills and Inflation Yearbook, Ibbotson Associates report the returns of various style portfolios from 1969 through 2003. During this 35-year period, growth stocks (defined as those with above-average price-to-bookvalue ratios) returned 9.3% compounded annually, while value stocks (those with below-average price-to-book value ratios) provided an 11.6% compound annual return. While impressive, even more dramatic is the return differential between small company value and growth stocks. Small company growth stocks returned 9.2% annually during the period while small company value stocks returned a whopping 15.2% a year. Furthermore, the differential favoring small company value stock portfolios was not confined to this relatively short period in history. Using a slightly different methodology to categorize stocks as growth and value, Eugene Fama and Kenneth French examined investment returns from 1927 through 2003. They found that growth stocks returned an average of 9.1% annually versus a 12.1% annual return for value stocks. During this period, small company stocks outperformed the Standard & Poor's 500 Index (12.7% versus 10.4%) and small company value stocks provided the greatest compound annual returns (14.7%).
To underscore the difference in returns favoring small value stocks, consider the fact that $1 invested in the S&P 500 Index in 1927 would have grown to $2,285 by the end of 2003. A similar investment in small company stocks would have grown to $10,954 while a $1investment in small company value stocks would have ballooned to $34,445. Of course, value stock returns don't top growth stock returns every year. In fact, value stocks performed rather poorly relative to growth stocks during the technology led stock market of the 1990s.
Why does value trump growth? Several academic studies of stock price performance indicate that investors overreact to bad news and under-react to good news. Thus, when a company reports negative news, investors tend to drive down the company's stock price well below its intrinsic value. Over time, stock price tends to move back toward intrinsic value as investors reevaluate improving prospects for these undervalued companies. On the other hand, growth stocks usually have high expectations built into them, thus the reporting of good news is accompanied by less upside price action than is the case for beaten down value stocks. This line of reasoning also explains the relatively better performance of small value stocks versus large value stocks. Because of limited liquidity small company stock prices react even more negatively to bad news and thus the differential between their prices and intrinsic value is magnified. Thus, the eventual rebound in price is much more pronounced for small company value stocks than is the case for the more liquid large company value stocks.
The Perritt MicroCap Opportunities Fund was founded on the belief that the stocks of small companies have the potential to outperform the stocks of larger companies and that a value-oriented portfolio could outperform most growth-oriented portfolios over the longer run. This is the underlying philosophy that has guided the Fund's stock selection process in the past and the philosophy that will govern the stock selection process in the future. Although a small company value portfolio might not be suitable for all investors, we believe that there is a place for this investment style in the portfolios of all long-term oriented capital appreciation seeking investors.
Dr. Gerald W. Perritt