Value and growth stocks and shareholder value creation in Brazil.
| Autor | Vasconcelos, Lucas Nogueira Cabral de |
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Introduction
Investment managers and equity analysts label high (low) book-to-market (B/M) firms as value (growth) companies. A substantially different growth is expected between those two types of stocks since the equity valuation models establish that the firm'svalue comes from its ability to generate cash flows (CF) (Sloan & You, 2015). Since these CF are expected in the long run, much of this value comes from the future film's investment opportunities (Tobin, 1969). Also, because these firms are often at distinct organizational life cycle stages (Miller & Friesen, 1984) and the shareholder value creation is determinate by the firm's profitability and growth (Varaiya, Kerin, & Weeks, 1987), there is a conventional wisdom that value and growth stocks have substantial differences in value creation for investors.
Based on the efficient market hypothesis (EMH), growth stocks are less risky than value stocks, due to the expected growth of companies (Santos & Montezano, 2011; Sloan & You, 2015; Chen, 2017). Given the above, in this study, we test the hypothesis that the growth stocks create greater value to shareholders (Varaiya et al., 1987) because they grow at a high rate than the value ones (Sloan & You, 2015; Chen, 2017). Hence, we analyze the relationship between B/M ratio, a standard measure of firm fundamental characteristics (with the profitability), changes in profitability and dividends growth rate in the Brazilian stock market.
For this purpose, we consider that greater shareholders value creation (whether of growth or value stocks) is represented by higher growth rates of return on equity (ROE) and dividends (or, simply, by higher "growth rate"). Also, we take the following steps: we investigate if B/M is a predictor of the levels of profitability; we investigate if B/M is a predictor of the annual changes in profitability; and if B/M is a predictor of the annual dividend per share growth rate. For this analysis, we use two correlation techniques, two types of portfolios' formation analysis and two univariate regressions to attest the robustness, besides some multivariate regressions with several control variables.
Our findings are a contribution to the study of the firms' growth dynamics and the valuation process in Brazil. These findings are original in their way of exploration in this market and contribute to filling the existing gap in this literature. First, in a practical perspective, this type of analysis is appealing for financial analysts and financial advisors to build dividends or quality portfolios' investment styles (e.g. they will have answers to questions about the comparability of growth and value stocks profitability and real dividend growth). Second, in a theoretical point of view, our analysis also represents an alternative test of the duration-based explanation for the value premium, since according to Chen (2017), several studies indicate that assets with higher duration are associated with lower returns. These studies show essential explanations for the value effect (Croce, Lettau, & Ludvigson, 2007; Lettau & Wachter, 2011). Also, we present an important advance on Chen (2017) in discussing the effect of growth on value and growth stocks in an emerging market, under the context of shareholder value creation.
According to Lettau and Wachter (2011), the term structure of equity is downward sloping. In other words, the long-duration assets earn lower expected returns. In their model, analogous to long-term bonds, growth firms are high-duration assets while value firms are low-duration assets. Companies with CF weighted more to the future, endogenously have high price ratios, while firms with CF weighted next to the present have low price ratios. A logical implication is that the growth stocks show lower expected returns due to their long equity duration and that the value stocks show high expected returns. Theoretically, this relationship could explain the value premium, or, from an empirical perspective, it could explain some heterogeneity of those kinds of firms.
Therefore, testing whether growth and value stocks have significant differences in the duration of their CF contributes to exposing evidence for this relationship in the Brazilian market. We have two reasons to conduct our study in the Brazilian stock market. First, such type of study is conventional in developed countries, especially in the USA, but it is still scarce in emerging markets, especially in Brazil. The Brazilian stock market has approximately 10 percent of its number of stocks traded in the US stock market, besides being a more volatile market and with less protection to shareholders (La Porta, Lopez-De-Silanes, Shleifer, & Vishny, 1997). For this reason, identifying firms as growth or value is a more difficult but essential task.
Second, if the duration-based explanation is a valid argument for the growth and value stocks divergence, a study conducted in Brazil will bring empirical evidence for this market, since there are mixed results related to the stock returns of growth and value firms. There is evidence of an inverted value premium: growth stocks/portfolios had high returns in the years 1990, 1991 and 1997 (Mescolin, Braga, & Costa, 1997), in 2001 and 2002 (Pedreira, 2005), in 1999, 2000, 2002, 2003, 2006 and 2007 (Saito, Savoia, & Sousa, 2014) and in the period between 1995 and 2008 (Cordeiro & Machado, 2013).
Our findings can be summarized as follows. The overall average of ROE of growth firms is significantly higher than that reported by value firms in almost every year after the portfolios' formation. The annual difference in ROE is not significant in the equally weighted portfolios, showing that the profitability of each firm shows little variation in the years after the portfolios' formation. Overall, contrary to the findings in the US market exposed by Chen (2017), growth companies show a massive dividend growth when compared to value companies in Brazil.
We conjecture a possible explanation. First, during the majority of the analyzed period (2000-2016), the biggest firms in Brazil could get relatively cheap financing by subsidized funding lines (Kayo, 2018), express a considerable growth in their profitability and, consequently, the possibility to make more significant dividends payout. Second, this phenomenon can reflect the mandatory distribution of dividends in Brazil, in addition to the high risk of this market, which makes the shareholder prefer the CF today (dividends) to keep it in the company. On the other hand, in the US market dividends are not mandatory and the risk is lower (greater protection for shareholders) (La Porta et al., 1997).
Our findings have the following practical applications. First, in the domestic market, growth companies are expected to experience higher dividend growth and a higher return on shareholders' equity, confirming the viability of valuation models based on multiples and dividend discount. In this case, how investors are looking to form a portfolio with dividend growth potential, in the long run, could invest in large growth stocks. However, it is crucial to observe the potential degree of overvaluation to avoid misallocation behaviors.
Also, the conventional wisdom holds that: compared to value stocks, the growth stocks have substantially higher future cash-flow growth rates and, consequently, longer cash-flow duration. Second, according to Chen (2017), in the US stock market, the growth stocks do not have substantially higher cash-flow growth rates, and in some scenarios, the value stocks CF appear to grow faster. His findings suggest that the duration-based explanation is unlikely to resolve the value premium in the USA. However, in the Brazilian stock market, growth companies show higher dividend growth and high profitability. These findings point to future research about value premium, including the effects of accounting and behavioral aspects.
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Book-to-market ratio and shareholder value creation
The B/M ratio is one of the oldest measures in the equity financial analysis and is generally used to differentiate between growth and value stocks (Graham & Dodd, 1934). According to Santos and Montezano (2011), for example, value stocks are usually defined as those traded at low price-to-book ratio (or market-to-book (M/B) ratio) and growth stocks, on the other hand, are traded at high price-to-book ratio (or M/B ratio). Although these authors used an inverted index (M/B) to what we use in this study (B/M), the conclusion is maintained by inverting the index and its understanding. Thus, when a firm shows a high B/M compared to the rest of the firms in the market, we have a value company. When the opposite happens, the firm is classified as a growth company.
According to the EMH, value stocks are inherently riskier than growth stocks, yielding, therefore, higher returns (Santos & Montezano, 2011). And value stocks have higher B/M exactly because the market would be efficient at the time it demands higher return so that its risk is offset, and its price is high. Tobin (1969) already noted that, according to the economic literature, B/M was associated with investment efficiency and company growth. This association derives from the substantial similarity and correlation between the M/B ratio and Tobin's (1969) Q, where the last one is generally calculated by the quotient of the market value of a company by the replacement costs of its fixed assets. In the difficulty of measuring the replacement costs, the M/B has been used, since the M/B variation results from the market value being able to capture future expectations associated with the investments made by the company, which can increase long-term stock returns (Fama & Barros, 2000).
Chen and Zhao (2006) observe that the M/B ratio reveals a company's investment opportunity, and its relationship to market timing and growth opportunity. In this context, if the expectation of greater growth...
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