Where do Stock Returns Come From? (EP.140)

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Mar 11, 2021

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INSIGHT

Price Convergence Explains Value Stock Gains

The anatomy of value/growth returns decomposes capital gains into book equity growth, convergence in price-to-book, and upward drift in valuations.
For value stocks capital gains come mostly from convergence (price-to-book rising), while for growth stocks gains come mostly from growth in book equity offset by negative convergence.

INSIGHT

Growth Firms Grow Fundamentals But Lose Valuation

Growth portfolios' capital gains mainly reflect growth in book equity from retained earnings, whereas value portfolios show little or negative book equity growth.
Growth stocks face a headwind: falling price-to-book (convergence) offsets much of their book-value-driven gains.

INSIGHT

Convergence Can Be Rational Or Behavioral

Fama and French accept both rational and behavioral explanations: predictable changes in profitability and mean reversion or investor misestimation can both explain convergence.
Empirically the facts hold regardless of interpretation; convergence and migration patterns drive returns either way.

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Where do stock returns actually come from? The answers to this deceptively simple question might change your investing perspective. We dive into this foundational investing topic after sharing community updates and chatting about our books and TV series of the week. A key concept in understanding where returns come from, we unpack how stock returns are impacted when companies migrate across size and value portfolios. While exploring how migration differently affects value and growth stocks, we also break down why book equity and growth drive capital gains for growth portfolios but not for value stocks. Linked to this, we discuss stock convergence as they relate to growth and value stocks. Looking deeper into the stock returns, we assess research on why valuation changes in asset classes are critical in determining expected returns. We touch on how valuations lead to an unfair depiction of international stock performance before asking: how justified are valuation changes to value and growth stocks? From understanding stock returns, we jump into our mini-planning topic on Canadian work from home tax reductions, followed by our Talking Sense segment. We wrap our conversation by sharing some bad financial advice. Join us to hear what it is, and to learn more about the anatomy of stock returns.

Key Points From This Episode:

More updates from the community and co-host Benjamin's battle bot building. [0:00:20]
Hear about The Defiant Ones, our TV series of the week. [0:02:50]
From The Coaching Habit to Elon Musk, we share our latest book reviews. [0:04:50]
Introducing our investing topic: the anatomy of stock returns. [0:10:00]
Exploring how changes to a stock type affect value premiums and returns. [0:13:40]
Why small stocks tend to have high returns compared with big stocks. [0:17:00]
Understanding the value premiums that underpin stock types. [0:18:45]
What happens when a stock improves in type. [0:21:32]
Factors that lead to price increases in growth and value stocks. [0:25:19]
The concept of stock convergence and how convergence impacts value and growth stocks. [0:28:45]
Behavioural explanations for the capital gains of value and growth stocks and the role played by stock drift and convergence. [0:32:25]
Whether historical returns tell us anything about expected returns. [0:34:15]
Why you should always include international stocks when assessing value stock performance. [0:39:18]
Using value spread to determine expected value premiums. [0:41:39]
We ask the question, "what if the trend in valuation changes to value and growth stocks are justified?" [0:44:17]
Diving into our planning topic: Canadian work from home tax deductions. [0:50:12]
How renters get a better deal than owners on work from home tax reductions. [0:52:25]
Hear our answers to the profound questions posed in our 'Talking Sense' section. [0:54:06]
Courtesy of Forbes, we share our bad financial advice of the week. [0:57:16]