growth vs. value
Why high P/E stocks are good for you
Here's a simple investing rule: risk pays. And that's why those risky growth stocks will always be better for your portfolio than value stocks.
By Victor Niederhoffer and Laurel Kenner
Value is back, at the wrong time and the wrong place -- just when investors should be loading up on growth and momentum plays.
Long thought to be the be-all and end-all of investment success, value strategies always come to the fore after a period when the Nasdaq ($COMPX) has shown unusual volatility or actually declined.
During recent years, however, as we show below, large growth stocks have outperformed large value stocks by a tremendous margin. Even within the Nasdaq 100 itself, cheaper stocks performed worse than more expensive ones.
Value rears its ugly head
Old-hearted men and women who have been buying low price-to-earnings ratio stocks for decades with nary a change in course come out of the bushes at times like this, and are given a respectful hearing:
Despite the dismal performance of his stock, the sage of Nebraska, Warren Buffett, was recently featured in a front-page New York Times article about 20-something investors giving up on tech stocks in favor of Buffett's Berkshire Hathaway (BRK.A, news, msgs). Since the Nasdaq 100 ($NDX.X) peaked March 27, Berkshire Hathaway has risen 27% as the tech-heavy index has fallen 30%. (Berkshire, however, is down 20% from a high set two and a half years ago, a period for which the Nasdaq 100 is still up 165%, even after this year's beatings.)
Two weeks ago, Barron's columnist Alan Abelson predicted a Nasdaq of 1,500 for next year, and nary a dissenting word was heard in the house.
The inventor of the phrase "irrational exuberance," Yale professor Robert J. Shiller, is back in the news again, this time to warn that stocks are still too high because the public isn't taking inflation seriously. In a book published earlier this year, Shiller noted that Fed Chairman Alan Greenspan "made his ‘irrational exuberance' speech two days after I had testified before him that market levels were irrational." He also gave the classic view of price-earnings (P/E) ratios: "Long-term investors do well when prices were low relative to earnings" for 10-year periods.
The opposite has been so clearly true for the past decade that one wonders how such a fallacy can continue.
Why the money is in growth
The main reason that growth investing will always outperform value investing is that markets pay an investor to lend long-term to companies with above-average rates of return. That's the process that leads to assets being deployed in their best possible uses. And that's the process that all stock exchanges show in their films to visitors to explain this. But strangely, the message has been lost.
Kenner & Niederhoffer
Victor Niederhoffer has traded stocks, currencies and futures worldwide for the past 40 years; he is the author of "The Education of a Speculator." Laurel Kenner is a trader and former Bloomberg markets editor. In this series of columns for MoneyCentral, they'll assess the past week's Wall Street performance and next week's prospects. Let us know what you think in the Start Investing Community.
Those who don't understand the purpose of a stock market have recommended that investors lend their money to companies providing stagnant products, on the ground that these companies represent value. But what is the cosmic purpose of an investor redeploying his assets from risk-free investments or his or her own business endeavors, many of which allow above-average returns, to these static industries? And why should such investors expect to tap into the 10%-per-year returns that investors at risk have realized over the last 200 years by lending to seemingly above-average growth situations?
A problem with almost all value studies we've seen is that they use results from stock-price databases that throw out companies with low P/E's that went bankrupt (artificially making the average of their low-P/E companies look better) and do not include very small high-P/E companies that later go on to greatness as growth stocks (artificially depressing the value of their databases' high-P/E stocks.).
Value by the numbers
Value Line's studies have provided an excellent alternative to the suspect conclusions of the academics. For more than 15 years, the stock-research and money management firm has endeavored to select the most representative group of value stocks for its customers. The sample starts with the companies in the Value Line Index -- the 1,500 to 1,800 biggest listed and Nasdaq issues as of the end of each year. For their value cohort, its researchers select the 10% of the companies with the lowest price-earnings, price-book and price-sales ratios. That's typically about 150 cheap companies.
From 1985 to 1999, here is how much value stocks have underperformed the broad Value Line Index in a portfolio balanced monthly:
Lowest P/E: -55%
Lowest P/S: -70%
Lowest P/B: -70%
Leveraging a variety of additional factors, Value Line researchers also select 100 companies that they believe will show superior performance each month. These companies they call "Group 1" and tend, in the main, to be growth businesses that have high earnings and price momentum. (In the unlikely event that a value stock was able to show superior earnings momentum relative to the past and expectations, it could find itself classified by Value Line as a Group 1 company.)
The results of our study support our view that the higher the P/E (the lower the E/P), the better.
The performance of these 100 Group 1 companies from 1985 to the present in a portfolio that has been rebalanced monthly has been about six times better than the broad Value Line Index. The absolute figures for Dec. 31, 1985 through Sept. 30, 2000:
Low P/E: -31%
Value Line Group 1: +655%
Value Line Geometric Index (median of VL stocks): +95%
What a difference between the prospective, real-time results of Value Line and the retrospective results of the academics and contrarians.
A guru of growth
We interviewed Samuel Eisenstadt, the research chairman of Value Line, who at 78 is as young-hearted as he was the day he joined the firm some 53 years ago. He believes growth will continue to outperform value, and feels so passionately about the issue that he went into the office extra early Wednesday to calculate those absolute return figures for us. What's amazing to him is that even in a year like this, where value funds have performed relatively well relative to the norms, the companies in the lowest P/E group continue to lag. The low P/E set is down, on average, 21% for the first nine months of the year, compared to an average move of up 11% for Value Line's Group 1 "growth" companies.
In our opinion, Mr. Eisenstadt's leadership in the research front at Value Line is the most remarkable demonstration of the practical success of a forecasting technique in the annals of forecasters throughout history. We tip our hat to Value Line for recognizing his extraordinary insights and techniques, a tribute to the value of simple common sense and systematic persistence.
We decided, as is our wont, to do a little counting of our own, to add some perspective on value vs. growth.
We selected a very narrow group, the Nasdaq 100, for just the last three years. This group is, of course, infamous to value types because of the high P/Es of the average member of the group. As we write, for example, the P/E of the Nasdaq 100, based on the last 12 months' earnings, is 137, and based on estimated earnings it is 87. These numbers are at least eight to 10 times higher than the usual recommendations and standards of the value types.
Within this group of highfliers, however, we hypothesized that the higher the P/E, the better the stock would perform.
We used the earnings-price ratio, or the earnings yield, rather than the usual P/E ratio, to test our theory. This does away with the discontinuities when a company loses money, as well as the meaninglessness of the P/E when earnings are very small.
The earnings-price ratio is nothing more than the inverse of the price-earnings ratio. A P/E of 10 corresponds to an E/P ratio of 0.1. Cisco Systems' (CSCO, news, msgs) 1998 P/E ratio of 99 corresponds to an E/P ratio of 0.01. Prophetically, Cisco's price appreciation in 1999 was 131%. PMC-Sierra (PMCS, news, msgs), at the end of 1998, had a 12-month deficit of 37 cents per share, and was trading at 63 1/8. The E/P, therefore, was -0.006. Its price appreciation during 1999 was 408%.
We used companies that were actually in the Nasdaq 100 at the end of 1997, 1998 and 1999. We calculated the price appreciation of these stocks in the next year relative to their earnings-price ratio at the beginning of the year as recorded in the S&P guide.
High P/Es are good P/Es
The results of our study support our view that the higher the P/E (the lower the E/P), the better.
We found 44 instances in which a company lost money and had a negative E/P ratio. These company's stocks gained an average of 100% in the next year.
The 44 companies with the lowest P/E (higher E/P) ratios returned an average of 47%.
The 183 companies that had middling earnings-price ratios, from 0 to 0.04 (corresponding to a P/E of 25 or more) returned a nice 72%.
We note a few cautions. For one, the high variability of the returns gives us only 90% confidence that these results are not due to chance variations alone. For another, our results are confirmed to Nasdaq 100 companies for the last three years, during which Nasdaq prices generally have soared.
However, all things considered, the results, in the vernacular, show that the higher the P/E, the better for Nasdaq 100 stocks, which is exactly what Eisenstadt found for the biggest 1,500 companies. The results, in conjunctions with Value Line's, are one more nail in the coffin of the value investment theory that has been the accepted wisdom of the academic and contrarian community.
The Nasdaq 100 companies with negative E/Ps, at present -- the candidates for superior performance, according to our study today -- are as follows:
Adelphia Communications (ADLAC, news, msgs)
Amazon.com (AMZN, news, msgs)
At Home (ATHM, news, msgs)
CMGI (CMGI, news, msgs)
EchoStar Communications (DISH, news, msgs)
Legato Systems (LGTO, news, msgs)
Level 3 Communications (LVLT, news, msgs)
McLeodUSA (MCLD, news, msgs)
Metromedia Fiber Network (MFNX, news, msgs)
Nextel Communications (NXTL, news, msgs)
USA Networks (USAI, news, msgs)
VoiceStream Wireless (VSTR, news, msgs)
Will these types of stocks continue to outperform in the future? Several of our readers have bluntly told us to go to Davy Jones's locker with our studies. How come you don't own these highfliers you're touting, they ask.
The answer is that these results are for year-end prices and earnings, with a one-year holding period for the stocks. We do intend to put our money where our mouth is on this one. We will provide a list of negative and low E/P companies near the end of the year, and after waiting a due interval so we're all on a level playing field, we intend to place some of our hard-earned cash from writing, and perhaps a few more from savings, into a little speculation on the least value-full of the Nasdaq 100.
moneycentral.msn.com
Jack |
