Trading Places

To say growth stock managers and their investors have it rough these days is an understatement worthy of the folks at Enron. Consider that the Nasdaq, a proxy for growth stocks, lost about 77 percent of its value from peak to trough. We could continue the body count by listing the negative returns of a legion of growth mangers, but it would be too cruel.

No doubt, growth devotees took another blow to the ribs with the news that President Bush wants to cut taxes on dividends for individuals (which might further dampen enthusiasm for non-dividend paying growth stocks).

But do not waiver: It's time for a growth rebound. The argument doesn't rest on the fact that it can't get any worse. The unprecedented seems to happen all the time, with unforeseen or discounted events springing from nowhere to destroy yet more wealth.

Rather, the argument for growth rests on the reversion-to-the-mean concept. Overly simplified, the concept means that when stocks (or any asset class) outperform their historical average, that asset class enters a period of underperformance and vice versa. In what would amount to a typical reversion-to-mean scenario, value stocks are due for a bout of underperformance. (See table below).

The enlightened advisor should be taking advantage of growth's depressed state (even as some are now questioning whether growth will ever work again) to start rebalancing portfolios. But just how far should the portfolio balance shift? Mark Binder, a Merrill Lynch senior vice president who handles equity allocations for the company's strategic investment management group, said he advocates a 70/30 value/growth split. “It's a stock-picker's market that should favor companies showing consistent growth and good cash flow,” he says.

Binder says finding the right balance between growth and value is important, but his current strategy also leans heavily on a belief that stocks will outperform bonds from present levels. “There are still a few one-off events out there that could derail the markets temporarily, but the second half of 2003 may surprise everyone with much better than expected growth, which would obviously be very favorable for equities.”

One of the reasons behind Binder's 70/30 split is the fact that value stocks tend to outperform growth stocks over the long haul. According to research from Dimensional Fund Advisors of Santa Monica, Calif., value stocks in both the large and small cap asset classes trounced growth by a wide margin from 1964-1997. DFA attributes the long-term outperformance to the additional risks associated with holding value stocks.

Still, even if you believe value is the place to be over the long term, it would be a mistake to ignore the fact that growth is starting to attract money again. If history is any guide, the upturn in growth stocks is the start of a move that could last several years or more.

If the reversion-to-mean argument isn't convincing enough, a case can be made for buying growth based on valuations. According to forward earnings estimates and historical relationship of the value/growth asset classes, growth is actually cheap relative to value; growth stocks have traded at a premium P/E multiple of about 58 percent over value stocks in the last couple of decades. In other words, a value stock trading at a P/E of 10 has historically been on par with a growth stock trading at a multiple of 15.8. This is the premium that investors have been willing to pay for growth stocks. If investors decide to attach a similar premium again, then growth is significantly undervalued.

The table at the top of this page lists the cap-weighted forward P/E estimates for the six major stock asset classes. To be sure, these numbers are only as good as the consensus earnings estimates. But even if imperfect, the degree of undervaluation is too large to ignore. If you believe investors eventually will decide to pay a decent premium again for growth stocks, and if the earnings estimates prove close to accurate, a shift towards growth makes sense.

When it comes to questions of risk, Kenneth French of Yale University and Eugene Fama of the University of Chicago come down in favor of growth. Why? Think of it like this: Value stocks are the equity of distressed companies with poor earnings and poor growth prospects — companies beset by fundamental business problems. Growth stocks, by contrast, typically are consistent earners with good prospects, and investors are willing to pay a premium for that.

The work of Merton Miller on the cost of capital (which earned him a Nobel Prize in 1990) shows clearly why a distressed “value” stock carries risk that is directly related to its level of distress. If a distressed company goes to the marketplace to raise capital (debt or equity), its cost for doing so is going to be higher than that of a healthy company. It makes sense that investors loaning money to a distressed company demand higher rates of return for assuming extra risk.

If you buy into the notion of embracing growth, how do you decide which asset class (small, mid and large cap) is best? The second table, above, can help guide the decision. Historically, large caps have attracted premiums, while small and mid caps have traded at relative P/E discounts of about 82 percent and 86 percent respectively. If the P/E premium historically paid for large-cap companies continues, then large caps deserve most of your money now, particularly given that large growth stocks are underpriced relative to large value stocks by about 14 percent. However, small- and mid-cap growth stocks also deserve attention, given that they are undervalued by 27 percent and 22 percent relative to their value-stock cousins.

The asset class choice is an important one, but not as important as the central message of this article: Ignore growth at your peril.

Stuart Chaussée is a former registered rep with Merrill Lynch. He now runs a fee-only advisory practice in Rolling Hills Estates, Calif. He is the author of three books. His most recent work is entitled Advanced Portfolio Management: Strategies for the Affluent.