There has been much academic discourse on fund managers stock valuation and recommendations using style investment strategies. Though there is weighty empirical evidence to suggest that value stocks outperforms growth stocks using different commonly used valuation indicators in international equities.
The above result is also consistent with results observed in the UK market. Relevant literature discussed in this proposal shows that when ranked according to price-to-earnings, price-to-book, price-to-cash-flow and dividend yield, Value shares outperformed growth shares in UK market. There are divergent views in explaining the rationale for this result with some authors stating that value premium is as a result of its high risk while others believe a contrarian approach. The use of another valuation indicator the PEG ratio by analysts in stock recommendation is becoming popular. Despite the PEG ratio returning better performance when compared with P/E ratio. A comprehensive study of its use in classifying investment style has not been undertaken, especially in the UK market.
The focus of this proposal is that this research will examine the performance of value and growth stocks in the UK market and especially the introduction of PEG ratio in the study to widen the knowledge in understanding the rationale for the outcome of the results of earlier studies. Data from 1992 to 2007 will be used as the quantitative research technique to buttress this research
One belief that is held in the investment world is the adoption of investment styles and the resultant performance of asset returns based on those styles. This belief according to Donald, 2008 “comprises of all that we know or think that we know about the ways asset returns are generated”. The commonly used investment style used by fund managers and investors is the value and growth styles.
Many empirical studies on this form of investment style have suggested that over the years, value shares outperforms growth shares irrespective of the valuation tool used fama and French (1992) and Lakonishok,Shiefer and Vishny (1994).In those studies the most commonly used valuation tools are the book to market and earnings to price ratios.
More recently fund managers are beginning to adopt another valuation tool the PEG ratio which adjusts the earning price ratio by its growth. The use of PEG ratio adjusts for one of the flaws of using P/E ratio in explaining difference in two comparable companies which is its growth rate Estrada (2005).Studies on this new valuation indicator is quiet scarce in measuring the performance of value shares against growth shares. Examining the outperformance of value shares over growth shares in UK becomes imperative with the use of this new valuation indicator and updated data that will be under study during this research.
Background study - London Stock Exchange
Due to the central geographical location of London with the other world timing zones making reference to it, London has assumed the financial centre of the world.
The London Stock exchange establish around 1700 has played a dominant role in the shaping the security market both domestically and intentionally Michie (1999). The capital market in London stock exchange according to Blake (2000) comprises of the FTSE 100, made of up the top 100 companies by market capitalization, FSTE 250,350 and ALLSHARE Index, each index comprises of the top total number of companies by market capitalization with the Allshare index making up the entire market.
The performance of the Uk market is consistent with the trends in other developed market when sorted by price to earnings.Fama and French 1998 found that annual returns of value stocks in UK were 17.46 while that of growth stocks were 14.81 in a data spanning between 1975-95.Before then using data from London Share Price database, showed that value shares(Lowest price/earnings ratio),had an annual of 17.76% while Growth shares (Highest price/earnings ratio) had an annual return of 10.80 in a data collected between 1961 to 1985 Tweedy,Browne,2008.Gregory,Harris and Michou (2001) updated the data from 1975-1998 and found that the average annual return over five years of portfolios sorted by earnings to price ratio show that the lowest rank deciles portfolio the (value)has a return of 24.62% while highest rank deciles portfolio (Growth)has a return of 20.64%.
1.2 Research Rationale
The Uk Stock market has not been extensively studied in terms of the value and growth investment performance unlike the US. Garry, Harris and Michiou studies of 1975-1998 remains the most comprehensive study of Uk performance of value shares over growth share in Uk Xinzhong (2001).Moreover, to the best of my knowledge, previous studies have not use the PEG ratio as a valuation indicator to examine if the returns will be consistent with returns when measured with earnings price ratio.
1.3 Research Aim
The purpose of this research is to compare the performance of value and growth shares using both P/E and PEG valuation tools in London Stock Exchange.
1.4 Research Objectives
To examine the performance of value stocks and growth stocks in the UK stock market between 1992-2007,using companies in FTSE 350(FTSE 350 is made up of 94% of total market by value).Which will be enough to describe market performance.
To examine if using the PEG ratio order than the P/E ratio used in other studies to classify the investment style, will give consistent explanation in the outperformance of Value shares over Growth shares.
To examine if the performance of Value shares and growth shares using current data sources will give a consistent result with earlier studies.
To establish using statistical analysis the significance of the result from the performance
2.0 Literature Review
This section would look at the views and writings of other researchers in the area of value and growth investment styles, and the usefulness of using either the P/E ratio or the PEG ratio in classifying the two investment styles in other markets. It would also show the contributions that have been made in this subject area particularly in the London Stock Exchange.
2.1 Value Vs Growth Investment style
Most investors in the equity market usually adopt style strategies in their investment decisions. This notion as explain earlier in this paper is termed out of the belief that has characterized most investment decisions, though most often, they are empirical evidence to support such beliefs. One of such belief is that of value shares and growth shares, empirical evidence in most markets studied so far shows that value shares outperform growth shares irrespective of the valuation indicator used. Using the mostly commonly used valuation indicators in classifying shares, value shares are generally defined as shares that have low earnings-to-price ratio in Basu 1977, low book-to-market ratio, Fama and French 1992, low cash-flow-to-price ratio, LSV, 1994, high dividend yield Keppler 1991 and low Price-to-earnings-growth, peters, 1991.While growth shares are regarded as shares that have high values of those valuation indicators described above and low dividend yield.
2.1.1 Price-to Earnings
In a study of over 500 stocks in US spanning a period of between 1957 to 1971,sorting the stocks from lowest P/E (value)to highest P/E (growth) portfolio,Basu,1977 showed that the lowest rank portfolio(value) stocks had an average annual rate of return of 16.3% while the highest ranked portfolio had an average annual rate of return of 9.3%.The outperformance of value stocks over growth stocks is also consistent with Fama and French study in 1992 using the same US market, with value stocks outperforming growth stocks with 0.68 points. In examining the effect of P/E ratios in Contrarian strategy, LVS, studied stocks in NYSE and the AMEX and sorted them according to their P/E, the result of the five years holding period investment returns shows that portfolios ranked by low P/E had an average annual return of 19.0% with highest ranked portfolio returning on average over the same five year period,11.4% LVS.1994.
This consistency of the value stocks performance prompt Bauman, Conover and Miller to study 20 other established markets to understand if the performance of value stocks and growth stocks will yield similar results as that of the US market, in a study spanning 10 years, the result of their study also showed that value stocks outperformed growth stocks in all the market studied with different valuation indicators including price-to-book ratio introduced by capaul-Rowley-Sharpe, Bauman, Conover and Miller,2000.They also found that the performance observed had a firm size effect.
Using updated data, Chan and Lakonishok, 2004 provided further evidence of the earlier results obtained from other studies done even when sales-to-price ratios were included in the valuation indicator. Their result also shows that irrespective of whether small cap or small cap stocks are considered, the value stocks outperformed growth stocks. They used the same methodology to study non-Us markets and observed the same result reported earlier by Bauman, Conover and Miller
2.1.2 Book-market ratio
This valuation method is used to identify shares that are trading in the stock market at either below their book value or above their book value. Value shares are classified as shares that trade at the stock market at less of their book value or intrinsic value while growth shares are classified as shares that trade at the stock market at above their book value.
Fama and French championed the evidence in further support of the performance of value stocks over growth stocks in their study of non-financial stocks in US market between 1963 to 1990, taking into consideration another factor in stocks returns, the market cap. They observed that stocks with lowest price to book returns better performance than stocks with highest price to book value and that in all the portolios,companies with smaller market cap also performs better than large cap stocks,Fama and French 1992.
The evidence above was also supported by Debondt and Thaler, ranking stocks in the US market based on their book value observed that returns of portfolio for lowest price/book value stocks performed significantly better than portfolios formed with highest price/book value stocks, taking cognisant of their returns prior to portfolio formation and after portfolio formation, Debondt and Thaler 1987.
International evidence of this study was provided by Sharpe, Capaul and Rowley 1993, in a study of major markets around the world including the US, stocks were ranked according to price to book value and formed into portfolio of value and growth. This study also included the UK market for a period of between 1981 to 1992.The result of their analysis shows that in all of the countries studied, value stocks outperformed growth stocks.
2.1.3 Cash-Flow-to Price
The ranking of portfolio according to cash-flow to price, in evaluation of value and growth investments, showed according to evidence from LSV, 1994 for portfolio formed between 1968 to 1990 in the US market. The result of the returns show that portfolio ranked by lowest price to cashflow ratio outperformed portfolio ranked by highest price to market ratio by 10.6 points. Further evidence from returns on strategy discovering undervalue stocks based on low price to cashflow ratio,Keppler,1991 noted that, empirical evidence from international equities supports that low price to cashflow stocks outperformed high price to cashflow stocks.
2.1.4 Price-Earning Growth
As already noted earlier one of the shortcomings of using P/E ratio to classify shares is its inability to differentiate two comparable companies. Though the classification of investment styles using PEG ratio is still very scarce in literature. But the increasing significance of its use can not be overlooked. According to Estrada,2005,studies on portfolios sorted by PEG, lowest ranked portfolios outperformed highest ranked portfolios between 1982 to 1989.That was the earliest study done in PEG valuation indicator according to literature.
Despite the shortcomings of using short-term earnings growth in estimating PEG, Easton 2003, observed a high correlation between estimation of expected rate of return of stocks using PEG when compared to estimation of returns using P/E ratio. In his study of how analysts use earnings forecast in generating stock recommendation Bradshaw, 2004, observed that analysts incorporate earning forecasts in their recommendation and the tests indicate that they value and recommend stocks based on the PEG ratio. Further evidence of the increasing use of PEG ratio in ranking stocks by analysts in international context was provided by Barniv, Hope, Myring and Thomas, 2009.
They observed that the strong positive relationship between analysts recommendation in US using PEG ratio also extend to other strong investing countries, although they noted that there is a negative relationship between analysts recommendation and future returns. Despite this evidence to show that analysts use PEG ratio to recommend stocks, there seems to be less work on the evaluation of performance of value stocks and growth stocks using this valuation indicator.
Though one can argue that since there is no relationship between analysts recommendation and future returns of stock, according to empirical evidence and since according to evidence from Estrada, 2005, the holding period return of stock valuation using P/E outperforms PEG ratio, that there should not be any need for study of the investment style performance of stocks using PEG ratio. But when assessment of returns includes the risk factor, the PEG ratio outperforms the P/E ratio in most risk assessment measures and assessing stocks return will be incomplete without implying the risk factor.
2.2 Value Vs Growth Investment Style in UK
The UK market being one of the strong investors market in the world, evidence of the performance of value shares and growth shares is consistent with the results of the US markets and other international markets described above irrespective of the valuation indicator used. When classified according to book to price value, Sharpe, Capaul and Rowley 1993 observed that low book to price shares outperformed high book to price shares by 31.5%, between 1981 to 1992. The performance of the Uk market is consistent with the trends in other developed market when sorted by price to earnings.Fama and French 1998 found that annual returns of value stocks in UK were 17.46 while that of growth stocks were 14.81 in a data spanning between 1975-95.
Before then according analysis of data from London Share Price database, showed that value shares(Lowest price/earnings ratio),had an annual of 17.76% while Growth shares (Highest price/earnings ratio) had an annual return of 10.80 in a data collected between 1961 to 1985 Tweedy, Browne 2009.Gregory,Harris and Michou (2001) updated the data from 1975-1998 and found that the average annual return over five years of portfolios sorted by earnings to price ratio show that the lowest rank deciles portfolio the (value)has a return of 24.62% while highest rank deciles portfolio (Growth)has a return of 20.64%.When ranked according to dividend yield, shares with high dividend yield are classified as value shares while shares with low dividend yield are classified as growth stocks. Levis 1989 observed that value stocks outperformed growth stocks by as much as 6.3% on annual investment return.
The consistency of these results has not been tested in the UK market using PEG ratio. The higher return on risk-adjusted measure of performance shown by stocks valuation using the PEG ratio over P/E ratio makes this study very important.
Though the consistence of value stocks over growth have not been attributed solely to either the valuation indicator used or investment style adopted.Fama and French attributed it to the riskiness of value stocks, but in his conclusion of empirical evidence studied, Chan and Lakonishok stated that investor’s behaviour could be at the root of this results.
This review of major studies in this section shows enormous work that have been done in examining value and growth stocks using different valuation indicators and still providing consistent results of outperformance of value stocks. Since there is still not a consensus among researchers as regards the explanation of this results. It shows that there is still ongoing research into understanding a testable rationale for choosing value stocks over growth stocks.
Quantitative research design connects research questions to data Punch 2005, p63. The research design will be to compare the performance of value and growth shares in the London Stock Exchange over the period to be studied. The P/E and PEG ratio will be the valuation indicators to be used.
In this section, the data collection and source procedure, portfolio formation approach, performance measures to be used in analyzing the research topic will be discussed. A framework of the timeframe to undertake this research will also be set.
3.1 Data Collection and Sampling
The benchmark to be used in the analysis will be the FTSE350 Index. The FTSE350 Index is made up of 94 percent of the market capitalization by values, which will be enough to describe the market performance. The data will be collected on monthly time series. The P/E ratio data will be sourced from DataStream and the preceding growth rate also from DataStream will be used to adjust the P/E in other to get the PEG ratio for the companies. The data type described above will be the primary data. The secondary data will be sourced from existing financial academic journals, unpublished conference papers and revered textbooks.
3.2 Portfolio Formation
The approach to be used in forming the portfolio will be that at the end of each preceding year that the portfolio will be formed, the data P/E ratio and earnings growth rate of the companies in FTSE350 in that year will be sourced from DataStream i.e,the portfolio to be held in 1992,will be formed at the end of 1991 and assumed to be held through-out 1992 before being sold at the end of 1992.The P/E and PEG ratio will be ranked from the lowest to the highest and divided into deciles. The lowest ranked deciles will form the value portfolio in that order to the highest ranked that will form the growth portfolio.
3.3 Analytical Methodology
Analysis of the data will be done using both economic and statistical analysis. Each analytical method intends to answer fundamental questions regarding the outcome of the results.
3.3.1 Economic Analysis
This is the analysis of the performance of the returns of both the value and growth portfolios. It intends to answer the question of which portfolio outperforms the other within the period investigated. It also intends to answer the question of which of the two valuation indicators gives a better indication of the performance of the portfolios i.e using P/E ratio and PEG ratio, which of them is mostly useful in valuing stocks. In economic analysis the financial measure of risk and returns is the most commonly used method.
The method of risk and return assessment depends also on the method of risk to be considered. The risk assessment method to be adopted in assessing the portfolio for this research includes; Sharpe ratio which uses the standard deviation as a measure of risk, the Treynor ratio that uses the beta of the security as a measure of risk. These two ratios uses the two traditional measures of risk i.e. the beta and standard deviation in evaluating performamce. Another method of evaluation performance to be used in this research though not widely used as the former two, is the risk-adjusted return.
Since the aim of this research is to examine the performance of value and growth shares, the use of risk-adjusted return will be appropriate since it is useful in comparing portfolios at different levels of risk Bacon 2004.The risk and return will be evaluated using the FTSE 350 Index as the benchmark and the returns of the shares in each portfolio will be based on value-weighted with the market capitalization as the value.
3.3.2 Statistical Analysis
The statistical analysis intends to answer the question of the significance of the variable in explaining the returns. In this case the significance of P/E and PEG ratio in explaining the returns of the portfolio. The hypothesis to test here will be the statistical significance of the valuation model used in explaining the outperformance of one of the valuation indicator used over the other.
Given that the research will be carried out over a period of three months, the following timeframe have been set to actualise the objective.
|June -09||1||Make corrections on submitted proposal based on feedback given from supervisor.|
|2||Initiate collection of primary data and formation of portfolio|
|3||Meet With Supervisor – discuss primary research plan and get the required advice|
|4||Start data analysis|
|Jul-09||1||Expand more on secondary research, review introduction and literature review|
|2||Meet with supervisor to review data analysis done so far|
|2||Meet with supervisor to discuss results|
|3||Bring findings together and prepare conclusion and recommendation|
|4||Put finishing touches to project and prepare to submit.|
The main aim of this proposal to show how the examination of value and growth shares in the UK market using PEG ratio can give a further insight on the consistency of the outperformance of value stocks from available empirical evidence. And since the study of PEG ratio in ranking stocks for classifying investment style is still scarce in literature especially in UK market. This will be an attempt in exploring that gap in knowledge which is the aim of this paper.
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