Growth and Value

Monday 03/31/14

   Judging by the major indices you would have probably thought that last week was a pretty uneventful week in the market. However, many of the hottest stocks sold off significantly last week; biotech, social media, and other trendy investments with lofty expectations were the biggest losers. While trendy stocks suffered a significant setback, many of the older “boring” companies performed very well. Although, it is still too early to call this a new trend, it appears that investors are rotating out of growth stocks and into value stocks. While there are many definitions for both growth and value stocks, this week we will look at some of the basic characteristics of growth and value.
     Growth stocks are typically defined as a company whose sales, earnings, or some other metric is expected to grow at an above average rate. A good example of a growth stock would be Priceline, its earnings, sales, and stock price have all expanded rapidly for many years. As you can see from the chart on the right, Priceline has rewarded investors for a considerable period of time. As a company develops a strong trend of earnings and sales growth, they will start to command a higher multiple. A price-to-earnings multiple is determined by dividing a company’s stock price by its earnings per share, price-to-sales is calculated by dividing the price by sales per share, and price-to-book is determined by dividing the stock price by the most recent book value of the company. Below Priceline’s stock price, you can see that all three of Priceline’s aforementioned ratios are much greater than average. Does this mean that Priceline is wildly overvalued? Not necessarily, expanded multiples means that the market has higher expectations for growth from Priceline. As long as Priceline can continue to meet those expectations then a higher multiple may be justified.
     However, not all growth stocks are created equally. Some growth stocks are growth stocks because their stock price has grown solely on anticipated future earnings, but the company has never actually lived up to those expectations in the past. Investors in these stocks are often referred to as momentum investors, they generally don’t care about the underlying fundamentals of the stock, but instead they will buy the stock because its share price has risen in the past. This leads to real and obvious (to some) overvaluation, but it can also reap enormous rewards for short term traders. A great example of a momentum stock would be Twitter. In December of 2013 Twitter’s stock price rose from about $40 per share to a high of over $73 by December 26. What made this near doubling in stock price all the more spectacular is that there was no new information or significant changes in Twitter’s fundamentals over this time period. Twitter is projected to make about $1.2 billion in earnings in 2015, but the total value of Twitter at its peak was around $40 billion. Short term traders helped add billions to Twitter’s valuation on a daily basis. Last week it seemed to be these type of momentum stocks that were hit the hardest. One interesting feature of growth stocks that are beat up significantly is that they often become value stocks and a completely different type of investor may become interested in them.
     Value stocks are often unloved stocks that trade at a very low value relative to their fundamentals. Value stocks will typically have low price-to-book, price-to-earnings, and price-to-sales ratios. Value investors tend to focus more on the numbers rather than the trends. Value stocks often come from industries that are perceived to be dying or are not that innovative. A great example of a value stock would be Hewlett Packard in late 2012. At the time, technology pundits were discussing the post-pc era and the transition to tablets away from PC’s and laptops. Investors did not want to have anything to do with Hewlett Packard whose stock price had been suffering for years. However, Hewlett Packard was trading below its book value and continued to generate a decent profit. As news became more positive and HP beat earnings, the company rose slowly and steadily throughout 2013 and nearly doubled in that time period.
Which is Better?
     The truth is that neither strategy is better. There are times when growth stocks will outperform value stocks and vice versa. A good value investor is patient and doesn’t buy too soon, whereas a good growth investor generally sells early. The value investor who recognized value and bought Hewlett Packard early at $25 saw their investment fall significantly before turning around and slowly rising to $32, whereas the best value investor bought later closer to $15 (of course, timing the exact bottom is nearly impossible). The better growth investor will sell early before growth starts to deteriorate. In aggregate, growth stocks tend to outperform earlier in the business cycle and value stocks tend to outperform later in the business cycle. Value tends to outperform when the yield curve is steep and growth outperforms when the yield curve is flat or inverted. If you are interested in learning more about investing in growth versus value, I highly recommend Style Investing by Richard Bernstein.
Index Closing Price Last Week YTD
SPY (S&P 500 ETF) 185.49 -0.71% 1.26%
IWM (Russell 2000 ETF) 114.29 -4.01% 0.85%
QQQ (Nasdaq 100 ETF) 87.05 -2.54% -0.33%

Social Media Stocks

Year-to-date performance of the Global X Social Media Index ETF.

Growth Stocks Versus Value Stocks

VUG is the Vanguard Growth ETF which tracks the performance of the The Center for Research in Security Prices large cap growth index. VTV tracks the large cap value index.


Priceline stock performance and current fundamentals.