Value or Growth: Which Side Are You On?


By Margaret Popper Today's equity market is to value investors what the Emperor Constantine was to early Christians -- a long-awaited vindicator of their beliefs. So far in 2001, there's no question that so-called value stocks have outperformed so-called growth stocks. The S&P 500/Barra Growth index fell 9.82%, while the S&P 500/Barra Value index rose by a puny 0.86%. O.K., that's not exactly a miraculous return, but it's got the advantage of being positive in a bear market.

The story for mid- and small-cap stocks is even better. The S&P Mid-Cap 400/Barra Growth index has lost 4.52% of its value since January, while the value index gained 7.37%. The S&P Small-Cap 600 Growth index has lost 3.64% so far this year, while the S&P Small-Cap 600 Value index has picked up 7.72%.

Does this mean that the gospel of value investing has finally vanquished the creed of growth-investing so popular during the dot-com frenzy? Unlikely. Even though current conditions favor value investing, and will probably continue to do so for some time, growth will rise again when the earnings dynamics are different.

Over time, the difference between growth and value returns is insignificant. Whether you use growth or value criteria, in a difficult earnings environment like this one it's more important to pay attention to the fundamentals of a company's business than it is to set investment criteria based solely on ratios like price-to-earnings or p-e to sales growth.

TROUGHS AND PEAKS. The two investing approaches tend to do better at opposite ends of the business cycle. Value outperforms when the cycle is near the bottom, earnings can't go much lower, and stocks are likely to be undervalued due to an overly pessimistic earnings outlook. It continues to do well as earnings start to come out of the trough. But growth does well late in the business cycle, when earnings are reaching their peak and investors are willing to bid up stock prices to get their hands on the fastest growth.

That's why value's time is nigh, and likely to continue for a couple of quarters. "Whether you believe the business cycle is nearing the bottom or starting the initial upswing, it's clear we're not at the end of the cycle," points out Milton Ezrati, senior economist and strategist at Jersey City-based Lord Abbett & Co.

Even though value is hot, it's too simplistic to say that those who bet big wads of cash on tech over the last couple of years should have learned their lesson about growth investing. In fact, all that the recent bear market has proven is that tech stocks are not automatically growth stocks. "Over the last couple of years, growth came to mean tech," says Marci Rossell, chief economist at Oppenheimer Funds. "In times of normal market behavior, growth and value just represent investing styles, not sectors."

SAME DIFFERENCE? While the past year has seen a satisfying reversal of value-stock returns over growth-stock returns, in the long run, the difference is minuscule. Over the past 10 years, the S&P 500/Barra Value index has yielded a 14.97% annualized return, vs. the S&P 500/Barra Growth index's return of 14.24%. That's a difference of only 0.73%. "The outperformance of one over the other is purely random," says Rossell. "For the smart investor, both should be part of a diversified investment portfolio."

Arguments other than returns can be made for following value rather than growth. "Even if the returns are equal, you get the same return with value for less gastric juice," says Ezrati. "Growth makes its performance in a very short period, while value makes money every year, and protects you on the downside."

For investors, that means choosing between a volatile portfolio that swings to dizzying heights in bull markets (like we saw in 1999) or a portfolio that doesn't require daily swills of Maalox because, while it misses out on those highs, it also avoids the lows of a bear market.

Growth devotees, as you can imagine, don't see much point in being so risk-averse over the near term. "If you're more interested in capital preservation than capital appreciation, why not invest in bonds?" asks Peter Trapp, portfolio manager for the New York City-based Needham Growth Fund.

GOTTA BE REASONABLE. Trapp is one of a growing school of self-styled "GARP" investors: growth at a reasonable price. "I use growth criteria with a value discipline," he says. Whereas a pure growth investor would be willing to pay one or more times growth, Trapp looks for stocks whose p-e multiples are half their estimated three-year growth rate.

"If, over three years, the company's earnings [are projected to] grow at 20%, I'll pay 10 times earnings or less," he adds. "I'll buy a stock that is trading at 20 times earnings, but I have to be convinced it's a 40% grower." That means understanding the fundamentals of a company and not investing unless these are sound. In deference to that principle, Trapp currently has about 22% of his fund in cash.

Value investors' interpretations of the investing style are about as varied as medieval Christians' definitions of their dogma, but if you listen closely, the bottom line is the same as GARP -- assessment of fundamentals. In the broadest terms, value investors are looking for companies that are trading at less than their real value and will turn around to release that value in their stock price.

Real value can be defined any number of ways. But once you start trying to figure out if that company is going to unlock this value so that the market recognizes it in the share price, you're back to examining the company's fundamental business prospects. "You want a company where something is going to change, either externally, like a fundamental change in its industry, or internally, like a change in management," says Chris Leavy, portfolio manager of the Oppenheimer Value Fund.

"BUGGY-WHIP FACTOR." The key to a successful value-investing strategy is in assessing qualitative factors. "We have 12 criteria that we use for picking stocks in our portfolios, 9 are quantitative and 3 are qualitative. The qualitative ones are the most important," says Nancy Tengler, CEO of San Francisco-based Fremont Funds. "There's the buggy-whip factor -- fear of product obsolescence, the franchise value you get from industry dominance, and management."

Those are the same criteria that growth investors worry about when trying to predict growth potential, but they're not put off if the stock is already on a rapid upswing. Throughout business cycles, "growth and value styles of investing tend to go in and out of favor," says Ezrati.

Value is in now, and it's likely to stay in for a few quarters -- at the very least until it becomes more clear if this economic downturn is bottoming. Whether you're a growth or a value investor, however, the absolute truth lies in the fundamentals. Popper covers the markets for BW Online in our daily Street Wise column


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