Pity the poor value investors. Nurtured on the elegant prose of Benjamin Graham, the folksy humor of Warren Buffett, and the daunting statistical elegance of Fama and French, they’ve languished in the wilderness with fifteen years of excruciating underperformance. What went wrong?Countless have taken no small pleasure in the misery of this unhappy band of brothers, for in many cases they constitute the sometimes less-than-humble Best and Brightest in finance. The cheap shot is all too tempting. Usually it doesn’t go much beyond a gleeful dunning of pointy-headed academics who wouldn’t know a stock ticket if one landed on their overhead projector.Another explanation, perhaps closer to the mark, is Rekenthaler’s Rule: "If the bozos know about it, it doesn’t work anymore." In other words, as soon as an anomaly is uncovered, it is arbitraged out of existence.The truth, I believe, is somewhat more complex and much more interesting. But first, if you haven’t yet done so, do read the piece "Of Mines, Farms, Forests, and Impatience," in the Spring 2001 issue, before proceeding. To recap, Irving Fisher’s mine is similar to a value stock—its cash flow is "front-loaded" and likely to slowly decrease over time. Fisher’s newly-planted forest is, of course, a growth stock, with zero income up front and dividends gradually kicking in as the decades wear on. Since the value of both of these enterprises is their total stream of annual income discounted to the present, an increase in the discount rate hurts the mine (value stock) much, much less than the forest (growth stock). I’ve slightly modified the graph from the last article in order to display this phenomenon.
The observation that higher interest rates are more harmful to growth than value stocks is not new, but there has been surprisingly little attention devoted to this in the growth-versus-value debate, particularly from a historical perspective.In order to examine the problem, I took advantage of Ken French’s wonderful Web site and downloaded the HmL series (a familiar Fama-French acronym for "high-minus-low" book value), which goes back to July 1926. This series basically represents the return of the top third of stocks sorted on book/price, minus the return of the bottom third. In other words, the value-minus-growth return difference. A positive number signifies higher returns for value stocks, and vice versa. The simple plot of monthly inflation versus HmL is an eye-crossing scattergram, but the slope of HmL on inflation is clearly positive, with a t stat of 2.91 and a p value of .0037. So there is indeed a significant positive correlation between inflation and value return, albeit a very noisy one....MORE