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 May 2007 Extreme Makeover The Line Between Value and Growth has Never Been Blurrier
Those were the days -- almost a decade ago now -- when they sky was the limit for the latest tech IPO. Any day without at least a 1% gain on the S&P 500 was considered sub-par. The Dow was hitting new 1000-point landmarks in record time and everything was powered by growth stocks.
Then came the turn of the century and the bubble finally burst. Growth stocks that had been market darlings quickly fell from grace, many never to return. Those that did languished not only in the bear market of 2000-2002, but also when the market finally turned, too. While the 1990s were the decade of growth, the current decade has been the decade of value. But a funny thing happened after five years of value-led growth: Value stocks have become expensive and the old growth warhorses are now values. Don't believe it? Just look at your value manager's holdings. In many instances, they look like they were plucked from the 1990s' growth stable. The portfolio described above is a case in point. As they say, what goes around comes around.
What's in a Name? Value investors had a lot to enjoy -- until their value stocks were no longer values. Energy and utilities, cyclicals and defensive stocks, ended up being market leaders as 2005 came to a close. Many value investors found they were falling behind as shares in these sectors continued to climb. To make matters, worse, some had mandates against holding cyclical energy stocks or had limits on their weightings of utilities. As both became more expensive, value managers -- real value managers -- couldn't pay the price and still consider them values.
With cash in hand and nowhere else to turn, they found themselves confronted with stocks that were still value priced: Fallen growth issues. That's right. The growth leaders from the 1990s were now values in 2006. As a result, many value portfolios are now mirror images of the growth portfolios of the 1990s. Can this really be the case or are managers changing their stripes? There have always been those who call themselves value managers or investors who ended up holding some of the growthiest of the growth issues. A prime example is mutual fund star (at least until last year) Bill Miller whose Legg Mason Value Trust has been known to own such growth icons as Google. No matter how you look at it, that's a clear stretch of the word "value". But that's not the case for a lot of the old growth issues. Many truly qualify as values -- at least by some definitions. As we've pointed out before, "value" can have two definitions, depending on where you fall on the investing spectrum. The first type is deep value, direct from the old Ben Graham school of investing. Deep value investors look to buy stocks below the intrinsic value. If a company's stock is priced this way, you're paying less than a dollar for a dollar's worth of assets. Eventually the world will notice and the price will return to fair value giving you a profit with minimal risk. Many people think of themselves as deep value investors, but truth be known, there really aren't that many true deep value stocks out there. Many that are belong to companies on the verge of bankruptcy and may ultimately return zero value to their equity investors. Instead of deep value, many investors fall into the other camp of "relative value" investing. A stock is a relative value if it's selling below the levels of the overall market, its competitors, or even itself when valued at different times. The underlying theme is to compare the stocks fundamentals to the market, others in its industry, or its own fundamentals at a prior time. For instance, if the S&P 500 has a forward P/E of 16x and the stock's P/E is 9x, then it's a relative value. Presumably its P/E will eventually catch back up to the market and you'll turn a profit in the process. Now here's the interesting thing: Stocks don't have to be traditional value stocks to be considered relative values. That's exactly what's been happening over the past few years and that's also why neglected growth stocks are now showing up on value managers radars. But don't just take our word for it, let's look at the numbers.
1999 or 2007?
At the same time, the forward P/E for the S&P 500 Pure Growth Index is 18.5x while the S&P 500 Pure Value Indexes' is 17.0x. (The two don't average to the overall S&P's P/E because not all of the S&P's stocks are represented in the Pure Indexes, only those that bear the truest growth and value characteristics. This suggests the stocks in the middle -- the core -- have lower P/E's than either of the Pure Indexes.) Just looking at the P/Es, you might conclude the value stocks are still cheaper than the growth, but that's not the whole story. First of all, the value sectors tend to always have lower P/Es than their growth counterparts. That's no surprise, that's why they're values in the deep value sense: Value stocks are priced closer to their intrinsic value. But in a relative sense -- the key concept of relative value -- growth stocks are actually cheaper. Why? Because they're now much closer to the low end of their historical P/E range. For example, the Pure Value Indexes' 17.0x P/E is 90% of its five and ten year averages. On the other hand, the Pure Growth's 18.5x P/E is 70% of its five year average and only 60% of its ten year average. In other words, the stocks of the Pure Growth Index are selling at a much greater discount to their historical averages. Even so, it's important to keep this in context. If you consider the where growth P/Es have been over the past five and ten years -- some well over 100x -- this may not be as meaningful as it first appears. It's one thing to sell at a discount to an historic average, but if that average was as overpriced as the growth average was in the late 1990s, it's quite another. In this case, value is in the eye of the beholder. Individual stocks offer another perspective. Just like the P/E of the S&P 500 Pure Growth Index, the P/Es of individual growth stocks are well below their five and ten year highs. Interestingly enough, as the P/Es have fallen, share prices have picked up. This has been going on a for awhile now, but started to accelerate in the past three months. This suggests that P/Es have fallen to the point where value investors are starting to nibble at the past decade's fallen growth stocks. To illustrate this point, we created a portfolio of ten stocks -- one representing each sector of the S&P 500. Each was considered a growth issue in the 1990s and until recently, each had fallen on tough times. Now things may be turning around for them. They appear on Chart 2. Of the ten stocks, only two have declined in the past three months (Harley-Davidson and Lehman Brothers) while a third has barely failed to keep pace with the S&P 500's 3.8% gain (Solectron). The rest handily outperformed the broader index. The average return for the portfolio over the period is 8.9%. From a valuation standpoint, even the deep value guys need to take note: The portfolio's average P/E is 12.5x, well below the S&P 500's 16.1x. From a relative value perspective, the forward P/E is 77% and 69% of the five and ten year averages, respectively. Skeptics may argue that the overall averages are artificially held down by Noble's booming profits in the energy sector. As you'll recall from fourth grade math, when you're looking at a ratio and the denominator is large -- in this case the 'E' in P/E -- the overall ratio will be lower. That explains why Noble's trading at 8.1x, but still can't explain why the rest of these old growth stocks only average 13.0x, still well below the S&P's 16.1x. Other things worth noting about these new value stocks is that on average, they're still 10% below their 52-week peaks whereas the S&P 500 closed on April 20, 2007 at a new 52-week high. In other words, our portfolio may still have some room to run as opposed to some of the other stocks of the index that may now be subject to profit taking. So it's understandable why value investors are turning to the fallen growth stocks of the 1990s. There's nothing wrong with that. Stocks move in and out of favor and successful investors pick up and act on the trends. If the past three months are any indication, large cap growth stocks -- or at least what used to be considered large cap growth stocks -- may finally be coming back into style, just this time as value stocks. Search this site! Just enter you key word or words:
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