Balancing Growth And Value Stocks
By James K. Glassman
Sunday, March 14, 1999
Not a few readers lately have accused me of throwing in the towel on value stocks. Untrue. I'm just doing a little reassessing.
Value stocks are stocks that seem to be bargains, left onthe shelf by investors reaching for trendier, more expensive items. Value stocks are easy to identify. They have, for instance, low price-to-earnings ratios--it costs fewer dollars to buy a dollar of their profits.
Growth, or momentum, stocks are the trendier items--companies whose profits, and prices, are growing quickly and whose P/E ratios are lofty.
While academic research shows value stocks beat growth, recent history is strikingly different. For the past five years in a row, growth has whipped value. For the last 36 months, the Vanguard Growth Index Fund, made up of stocks in the Standard & Poor's 500 index with growth characteristics, has returned 145 percent while the Vanguard Value Index Fund has returned 80 percent. So far this year, growth has returned twice as much as value.
Is this an aberration, or is something changing?
No one can tell, but investors who put all their eggs in the value basket are making a huge mistake. Economist Kevin Hassett and I have concluded, in work we are doing for a book on the market, that strong, consistent growth is essential to a stock's success. A company that is simply cheap--that trades, say, at a P/E of 8 but whose profits are just limping along--is not a stock we want to own.
How much growth? A company that can regularly increase its earnings (and its dividends) by double-digit rates annually is the ideal. Such stocks exist. Look at Automatic Data Processing Inc. (AUD), which provides payroll and other accounting services. It has boosted profits by double digits every year since 1963. Its stock, at a P/E of 34, could triple and still be sensibly priced.
Still, we would not want to abandon the "margin of safety" concept of the late Benjamin Graham, probably the greatest investment mind of the century. In other words, it's better to buy cheap.
The answer to this puzzle is to search for stocks that combine both growth and value--fast growers that are underappreciated.
A good place to start is with investor Warren Buffett's own portfolio, the listed stocks held by his company, Berkshire Hathaway Inc. (BRK/A). Timothy Vick, editor of Today's Value Investor (219-852-3200), a newsletter whose title sums up its approach, recently noted that "while Buffett's portfolio seems diversified, the bulk of his stock assets are tied up in five companies."
In fact, one-third of the $36 billion worth of listed stock owned by Berkshire is in just one company--Coca-Cola Co. (KO), a superb example of a fast-growing firm whose stock has languished.
Coke shares have fallen 30 percent from their July 1998 high, taking a pause that refreshes after more than quadrupling since 1994. Earnings have recently flattened out for Coke, and sour investors have knocked the firm's P/E down to 44--still about one-third higher than average for an S&P stock.
But Coke has a lot going for it, including the best brand name in the world. The company's earnings have grown at an 18 percent clip, on average, for the past 10 years. Value Line expects growth to modulate to just 12 percent for the next five years, but that's still pretty spectacular.
Even at a 10 percent growth rate, Coke's profits will grow by a factor of eight in the next 20 years--up to nearly $12 per share.
Meanwhile, Dow Theory Forecasts, a sister publication to Vick's value letter, has cranked up its computers and come up with what it calls "momentum plays for value investors"--in other words, stocks that combine growth and value.
The five best:
Alcoa Inc. (AA), the giant aluminum company, increased its fourth-quarter profit by 15 percent on a sales gain of 27 percent. Long-term earnings growth, according to Bloomberg News, has been 10 percent annually, but the stock, down nearly one-fifth from its high, trades at a P/E of just 16. The dividend yield is an attractive 2 percent--and, based on history, the payout will double every five years.
ECI Telecom Ltd. (ECILF) is a company based in Israel that does worldwide business and trades on the Nasdaq Stock Market. The firm sells digital telecommunications equipment to large network operators. "ECI has posted impressive sales, cash flow, and earnings growth over the last five years," writes the Dow Theory analyst. For 1999, its profit should grow about 18 percent. Yet the stock trades at a P/E of only 16, based on those earnings estimates.
Harrah's Entertainment Inc. (HET), operates 18 casinos in the United States and Australia. Although visitor volume in Las Vegas jumped 7 percent in December, gaming stocks continue to trade far below their highs (Harrah's is down 30 percent in the past 12 months), mainly because investors worry about overbuilding. Still, Harrah's has weathered problems before, and its historic earnings growth rate is 15 percent--exceptional for a company that trades at a P/E of just 14 (or 11, based on this year's projections).
Mylan Laboratories Inc. (MYL), the world's second-largest maker of generic drugs, faces a federal antitrust suit for allegedly cornering the market in lorazepan andclorazepate, two popular anti-anxiety medications. The legal action has made investors anxious, but Mylan is a remarkable company whose profits surged 36 percent last year and have averaged 13 percent growth for the past decade. Despite the suit, Dow Theory estimates profits will increase 20 percent annually over the next five years--not bad for a company with a P/E of 24.
Southwest Airlines Co. (LUV), a longtime favorite of ours, is now the nation's fifth-largest carrier, last year carrying 53 million passengers to 53 cities. Value Line says that the company "should benefit from entering new markets," including New York, with its super-efficient operation (a plane flies nine legs a day--twice the industry average). Profits have grown at a 23 percent rate for the past five years and should increase 18 percent for the next five, says Value Line. Meanwhile, the stock trades at a reasonable P/E of 24.
Finally, Al Frank, editor of the Prudent Speculator (1-800-258-7786) and a successful value-stock picker for 22 years, takes issue with Alan Greenspan's comment before the Senate Banking Committee recently that "stock prices are high enough to raise questions about whether shares are overvalued."
Questions, yes. Certainly, some stocks (mainly those without earnings) are too expensive. But others, says Frank, are not--and they just happen to combine growth and value.
But they are riskier than Coca-Cola and Southwest.
Frank cites Conseco Inc. (CNC), the financial-services holding company whose shares have plunged 40 percent in a year but whose long-term profit growth is 15 percent. The firm, which acquired Green Tree Financial Corp. last year, trades at a P/E--based on estimates for the year ahead--of just 7.
He also likes R.G. Barry Corp. (RGB), a micro-cap company that makes specialized footwear. After a solid history of profits, the stock has plummeted by half since July on a bad earnings report. The P/E is now a mere 6.
Or what about Fruit of the Loom Ltd. (FTL), the underwear maker, which has fallen by two-thirds in a year, trades at a P/E of 7 but has long-term earnings growth of 13 percent.
Still, I prefer consistent sharks such as Automatic Data Processing to such bottom fish. Does that sound like tossing in the towel? Maybe just a washcloth.
Glassman's e-mail address is jkglassman@aol.com; he welcomes comments but cannot answer all queries.
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