stocks, boosting their holdings of these issues. The 2000 to 2006 small
stock surge followed the collapse of large-cap tech stocks in the bubble of
the late 1990s, which again turned investors’ attention to smaller issues.
Whatever the reasons for the small stock surges, the trendiness of
small stock returns does not mean that investors should avoid these
firms. Small- and mid-cap stocks not in a big capitalization index such as
the S&P 500 Index constitute about 20 percent of the market value of all
U.S. stocks. One should be warned, however, that the existence of the
small stock premium does not mean that small stocks will outperform
large stocks every year, or even every decade.
VALUATION
Value Stocks Offer Higher Returns Than Growth Stocks
The second dimension along which stocks are classified is by valuation—
that is, factors relating the price of the stock relative to some fundamen-
tal metric of firm worth, such as dividends, earnings, book values, and
cash flows. Like small-cap stocks, Fama and French determined that
stocks that were cheap relative to these fundamentals had higher returns
than would be predicted by the capital asset pricing model.
Stocks whose prices are low relative to these fundamentals are
calledvaluestocks, while those with prices high relative to these funda-
mentals are called growthstocks. Prior to the 1980s, value stocks were
often called cyclical stocksbecause low-P-E stocks were often found in
those industries whose profits were closely tied to the business cycle.
With the growth of style investing, equity managers that specialized
in these stocks were uncomfortable with the “cyclical” moniker and
greatly preferred the term “value.”
Value stocks generally occur in such industries as oil, motor, fi-
nance, and utilities where investors have low expectations of future
growth or believe that profits are strongly tied to the business cycle,
while growth stocks are generally found in such industries as high tech-
nology, brand-name consumer products, and healthcare where investors
expect profits either to grow quickly or to be more resistant to the busi-
ness cycle.
Of the 10 largest U.S.-based corporations by market value at the
end of 2006, Exxon Mobil, Citigroup, and Bank of America had a low
price relative to fundamentals and were considered “value stocks” while
Microsoft, Procter & Gamble, and Johnson & Johnson had higher prices,
consistent with “growth stocks.”
144 PART 2 Valuation, Style Investing, and Global Markets