When you think about the top figures in investing, one of the first to come to mind is Warren Buffett. Known for his authenticity, investing aphorisms and immense wealth, Buffett subscribe to a school of investing called value investing. In the long-run, Buffett has capitalized on a premium for value stocks, a methodology that you can employ to increase the returns of your own portfolio.
Value stocks are companies trading at a price below their intrinsic worth. Determining what constitutes the intrinsic value of a company is a gray area, but the value of a company is generally defined based on financial ratios like price-to-earnings. Price-to-earnings is the ratio of the current share price to the company’s earnings per share; effectively, it measures how much you pay for the profit the company generates. If a company has a very low price-to-earnings ratio, that means that you pay a low price for the profits of the company. Thus, the ratio indicates that the market might undervalue the company, and the price should be higher given the profits it earns.
On the other end of the spectrum are growth stocks — companies trading at a price higher than their current worth. In the case of a growth stock, the price-to-earnings ratio is very high; as an investor, you pay a high price for the current profits of the company. In fact, many growth companies do not earn a profit at all. The high price relative to earnings means that investors predict high expansion in the future, which justifies the high price compared to current profits (hence the name growth).
Since 1926, U.S. value stocks have earned an average annual return of 12.7%, compared to 9.7% of growth stocks. The persistence of the trend is called the “value premium” — a higher return for value stocks compared to growth stocks.
You might be thinking, “Why shouldn’t I just invest all my money in value stocks? I know they’re undervalued, and it worked for Warren Buffett!” Well, over the past 10 years, we have seen a reversal of the value premium. While the average annualized return of value stocks has been 12.9%, the return of growth stocks has exploded to 16.3%.
Just because a value premium has existed over the past 100 years does not guarantee its existence in the future. Perhaps more importantly, it does not guarantee the outperformance of value stocks over growth stocks in any given year, so it would be unwise to make short-term bets relating to value stocks. However, a way to benefit from the value premium is by adding a “value tilt” to your portfolio — slightly overweighting the equity in your portfolio with value stocks.
In short, academic research has shown a value premium. Within the subset of U.S. equities, value stocks have outperformed growth stocks. However, over the past 10 years, there has been a reversal of the trend. Overall, if you trust the long-term persistence of the phenomenon, adding a value tilt to your portfolio can increase your returns.