Growth May Still Be A Better Bet Than Value
September 01, 1998 8:08 PM
By Vito J. Racanelli
Barron's Online
NEW YORK (Dow Jones)--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.
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.
Home Depot, Pfizer, Lowe's Touted
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 Inc. (PFE),
Home Depot Inc. (HD) and Lowe's Cos. (LOW),
which had P/Es of about 37-times, 31-times and
22-times forward consensus earnings estimates.
That's significantly above the market's multiple of less
than 19-times 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 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.
Dow Chemical Looks Attractive
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 Co. (DOW), which sells at
about 13-times 1998 consensus profit estimates and at
14.5-times 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.
So far, the high P/E growth stocks are hanging tough -
even when the market crumbles all around them. And if
the growth bulls are right, value players might have to sit
in the shadows for a good while longer.
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