Weekday Trader
Growth May Still Be a Better Bet Than Value
By Vito J. Racanelli
Put out that big fat cigar and put on your flak jacket.
On Monday, the major equity indexes fell inches away from official bear
market territory, then rebounded sharply Tuesday. But they remain down
some 16% from the highs they hit six weeks ago.
In times like this, investors' natural impulse is to play defense by
dusting off their Graham and Dodd and looking for value. Many studies
have suggested that in the long run stocks with low price-to-earnings
(P/E), price-to-book or price-to-sales ratios outperform growth stocks
with higher P/Es. By snaring undervalued shares, investors hope to limit
their risk in a market downturn and earn better returns when stocks
rebound.
But Merrill Lynch's chief quantitative strategist Richard Bernstein
advises investors to "continue to avoid value." With corporate profits
set to decelerate for some time, a growth strategy will outperform the
traditional value strategy in this kind of market, he writes in a recent
report.
Bernstein wasn't available to comment Tuesday, but Merrill Lynch
quantitative strategist Kari Bayer says the brokerage's studies of its
own value- and growth-oriented funds since the early 1970s indicates that
value strategies tend to do better when the profit cycle accelerates (see
chart). Growth strategies, however, outperform when earnings are
decelerating -- which is the case now, she notes.
U.S. profits growth has been moderating since the first quarter of 1995,
and it now appears headed to a "full-blown profits recession." First Call
shows consensus profit growth expectations of 5% this year and 7% next
year, down sharply from 1997. But many believe both the 1998 and 1999
numbers will have to come down even further as the economy slows.
In such an environment, a shift to value strategies would be premature,
she asserts. Why? Because, Bayer says, high-quality growth stocks that
best maintain their profits will be awarded the highest multiples, and
low-P/E stocks will lag. For example, for the three months ended July
31, 1998, Merrill Lynch's value funds lost anywhere from 7.4% to 13.1%,
while its growth funds were off from 0.1% to 6.4%. And since the 1970s,
the firm's growth funds have outperformed its value funds whenever
profits began heading downward.
Only when profits start to reignite across sectors will investors become
"comparison shoppers" and look for value, she adds. A rate reduction is
key, but it have to produce the kind of accelerated economic growth that
would help value stocks rack up bigger-than-expected returns. Such a
scenario appears unlikely over the next few months.
In other words, the same narrow group of high-P/E winners should continue
to exert leadership this year, even if the market falls and profits
continue to drop. (Of course, in recent weeks many of those high-P/E blue
chips finally succumbed to the bearish forces already at work in the rest
of the market.)
In particular, Bernstein would overweight consumer cyclicals, especially
retailers. His department's model stock portfolio includes such names as
Pfizer, Home Depot and Lowe's, which had P/Es of about 37x, 31x and 22x
forward consensus earnings estimates. That's significantly above the
market's multiple of less than 19x 1999 estimates as of Monday's close --
but much lower than these stocks' own high multiples for the year.
Despite Bernstein's findings, many investors reflexively shy away from
high P/E stocks in turbulent times like these.
One of them is Randall Eley, chief investment officer at the large-cap
value The Edgar Lomax funds. With the market's downturn, he says he will
step up the search for values in such beaten-up groups as energy and
financials, as well as the more traditional haven of utility stocks.
"We are going to take the classical Graham and Dodd approach," he says.
In bear markets the balance sheet is a key to the company's ability to
weather the storm. And low price-to-book, low price-to-earnings and high
dividend yield will all be important determinants of stock choices, he
adds.
If interest rates fall, Eley adds he'll be looking in another beaten-up
area: basic industries. Pricing power is notoriously absent in many of
these industries -- steel, paper and chemicals, for example -- but the
shares have already taken the kind of beating that others are
experiencing only now, he adds. Eley says Dow Chemical, which sells at
about 13 times 1998 consensus profit estimates and at 14.5x 1999
estimates, looks attractive.
And David Schafer, who runs the Strong Schafer Value Fund, warns that in
the brutal 1973-74 bear market, the Nifty Fifty blue chips held up well
at first but "all of a sudden the market threw in the towel on growth."
By 1975, low P/E stocks were far outperforming both the S&P 500 and the
Nifty Fifty, he recalls. |
