Test yourself again. Which stocks are more likely to generate a higher return, those with a low price-to-book value or a high P/B ratio? If you don’t recall the answer, run a search on Fama & French and read those posts again on this blog.
Roger Ibbotson also answered this question in his “Decile Portfolios of the New York Stock Exchange, 1967-1984″ paper where he examined the relationships between stock price and book value. [You will sometimes see the reciprocal of the P/B ratio. For some reason, I find it easier to work with the P/B ratio rather than the B/P or Book/Market ratio.]
Ibbotson’s study is very much like the F&F study in that he broke the NYSE stocks into deciles as ranked by their price to book value and price to earnings ratios. Over the 18-year period, 1967-1984, the return for all NYSE stocks was approximately 8.6%. That is just about the historical average for the broad market. Swedroe includes a table of Ibbotson’s results on page 172 of his book, “What Wall Street Doesn’t Want You To Know.” If we first look at the P/B ratios, cheap to expensive, the decile with the lowest P/B ratio had an annual return of 14.4% while the most expensive decile or high P/B ratio returned only 6.1%. As in the F&F study, there was a stair-step correlation, although not quite as consistent as found in the Fama & French study. The top three cheap deciles all ended up with 14.4% returns and there was also one break in the results down at the 9th and 10th decile. Did the P/E ratio provide similar results? Yes, but there were a few more cracks in the stair-step correlation. The decile with the lowest P/E ratio returned an annual 14.1% or similar to the results for the P/B study. The most expensive or decile with the highest P/E ratio returned an annual 5.6%.
If one takes these studies seriously, and we do, then it is prudent to skew a portfolio toward value or “cheap” stocks. We define “cheap” as stocks with a low P/B ratios as well as a low P/E ratios. One does need to keep in mind that there are periods when growth will outperform value, but we are going with the probability of long-term results.
As I recall, both Ibbotson and Fama-French rebalanced the portfolios once a year. This varies from the way the portfolios are tracked here at ITA Wealth Management as I am examining each portfolio once a month. It is difficult to know if this changes the results. For investors interested in yield, there is no question that value ETFs such as VTV, VOE, and VBR throw off higher dividends than VUG, VOT, and VBK.