Question

Growth and value can be defined in several ways. Growth usually conveys the idea of a portfolio emphasizing or including only companies believed to possess above-average future rates of per-share earnings growth. Low current yield, high price-to-book ratios, and high price-to-earnings ratios are typical characteristics of such portfolios. Value usually conveys the idea of portfolios emphasizing or including only issues currently showing low price-to-book ratios, low price-to-earnings ratios, above-average levels of dividend yield, and market prices believed to be below the issues’ intrinsic values.

a. Identify and provide reasons why, over an extended period of time, value-stock investing might outperform growth-stock investing.

b. Explain why the outcome suggested in ( a ) should not be possible in a market widely regarded as being highly efficient.

Short answer

The correct answer is:

a. Overestimation of growth stocks by investors

b. The current prices of stocks already reflect all known, relevant information

Step-by-step solution

Reasons for value stock to outperform growth stock

a. The earnings including dividend growth rates of growth stocks may be consistently overestimated by investors thereby downplaying the inevitable slowdown. Therefore over an extended future time, growth stocks are likely to revert to lower mean returns while value stocks are likely to revert to higher mean returns, often over an extended future time horizon.

Reason for suggested outcome to be not possible

b. Since, in efficient markets, the current prices of stocks already reflect all known, relevant information therefore the growth stocks and value stocks provide the same risk-adjusted expected return.