The reason behind the long-term underperformance of the so-called growth stocks

There is plenty of academic research showing that, on average in the long run, value stocks − defined by academics as stocks with low price-to-earnings , or price-to-book ratios – beat growth stocks – defined as stocks with high P/E or P/B ratios. For example, in recent research I carried out using U.S. data over the period from August, 1966, to October, 2019, I found that value stocks beat growth stocks by about 7 per cent. The results are similar for Canadian and international markets.

What could be the reason? As I indicated earlier, a high P/E ratio implies a high expectation of growth. Low P/E implies a low-growth expectation. If we are pessimistic about growth and we get bad numbers, in some way we expected it. But if we are optimistic about growth and we get bad numbers, we are very disappointed and react negatively. An analogous explanation can be given in the case when there are positive earnings surprises.

I found that while the value premium was evident in the total sample , the premium appears to be driven primarily by firms in the poorly earning quality portfolios. The intuition is that as growth firms, on average, tend to be bid up by investors, the less-visible ones – which tend to have poorer earnings quality – are bid up the most and end up having lower returns than better-quality growth stocks. For value stocks, there is no evidence that poorer earnings quality exerts a discernible effect.

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