First, let's discuss the value premium. Historically, value stocks have outperformed growth stocks. However, there are various fundamental ratios that can be used to distinguish between the two groups. The most frequently used ones are:
- Book-to-market (BtM)
- Earnings-to-price (E/P)
- Cash flow-to-price (C/P)
- Dividend-to-price (D/P)
Economists typically define value stocks as those that rank in the highest 30 percent by BtM and growth stocks as those that rank in the bottom 30 percent -- the middle 40 percent are called core. An August 2008 paper "Defining Value and Growth" by James Davis and Inmoo Lee of Dimensional Fund Advisors examined the results of various value strategies. The following is a summary of their findings:
- While there's substantial overlap in the rankings (for example, about 50 percent of the stocks defined as value by BtM are also defined as value by C/P), there are substantial differences. This can result in material differences in returns.
- When using market-cap-weighted returns (as equal weighting would create excessive turnover) for the period June 1964-June 2008, D/P produced the lowest value premium.
Annual Premium (%)
However, looking only at the premiums of the different value strategies isn't sufficient to determine the best value strategy. There are two other considerations we'll discuss in our next post: turnover and diversification.