Numerous studies have shown that over long periods, value investing outperforms growth investing on average but value stocks today are starting to look overpriced

By TEH HOOI LING
SENIOR CORRESPONDENT

	Email this article
	Print article
	Feedback

In the past two years there have been some who held the view that growth will come back into favour. But that has not quite happened yet.

In a presentation this week, asset management firm Alliance Bernstein explains why it thinks that investors should pay closer attention to growth stocks at this stage of the economic cycle. Indeed, it reckons growth stocks have never been this cheap before.

Value investors generally look for 'out-of-favour' companies. They look for discounts and seek stocks with relatively low price-earnings multiples.

Growth investors, on the other hand, look for fast earnings growth and are willing to pay a premium for it. So the stocks they buy into - in the hope of getting exposure to new products, innovation and a big increase in the share price - tend to trade at higher PE ratios.

However, numerous studies have shown that over long periods, value investing outperforms growth investing on average.

The problem with growth investing is that forecasts for exciting companies tend to be over-optimistic. Too much of the future has been built into their share price. So any disappointment sends that price crashing.

But when it comes to value companies, investors tend to be too pessimistic. So even the slightest improvement boosts their share price.

As Jimmy Pang, senior portfolio manager of Alliance Bernstein pointed out during the presentation, a reversion to the mean is good for value stocks but bad for growth stocks.

Empirical studies have shown that since 2001/2002, more money has flowed into value stocks than growth stocks, internationally and in the US.

The timing could not have been better. This was the period when the world economy was emerging from the dotcom bust and this region from the Sars scare.

Companies on the brink of bankruptcy, whose value was severely depressed, bounced back as conditions changed for the better. And their shares performed spectacularly.

With the economy having chugged along fine for the past three or four years, most companies are now generating some kind of profit.

Hence the discount - which was huge on loss-making companies in the bad times - has become smaller, if it hasn't disappeared altogether.

As globalisation deepens, the boom and bust cycle will become less pronounced. And in this more stable environment, companies that are better able to plan and execute their growth strategies will be the big winners.

Mr Pang says that the way to do growth investing is to look for companies that can sustain their earnings growth faster than the market thinks. This will lead to stock price outperformance.

'What hurts growth investors the most is when they stay too long in the stock,' he says. 'As soon as our expectations become close to market consensus, we start to trim our position and get out of the growth trap.'

Small gap

According to him, with investors flocking to value stocks and eschewing growth stocks for the past few years, we have reached a point where 'there is very little value to wring out of value companies but there is a lot of value to be found in growth companies'.

The price gap between growth and value - based on various metrics such as price-to-sales, price-to-book, price-to-cash earnings and price-to-forecast earnings - has never been so small, he says.

And when one looks at the price-to-cash flow of large-cap growth and value stocks, there isn't much difference either. 'This doesn't make sense. You are getting high growth for free. This can't persist,' says Mr Pang.

Alliance Bernstein's analysis shows that at the current S&P 500 level, only about 20 per cent of the share price is assigned to future growth. This is 34 per cent below the average in the past 25 years.

As for the MSCI World Index, the historical average for the most expensive company is 51 times its trailing earnings. And for the cheapest company it is nine times. In March 2000 the most expensive company traded to as high as 110 times its earnings. Today, the most expensive company is trading at 41 times its earnings and the cheapest at 11 times.

'There's been compression of valuation. Growth has become cheaper and value more expensive,' says Mr Pang.

Timing tricky

As global growth slackens and more companies begin to disappoint, investors will value growth more as it becomes more scarce, he says. 'These cycles typically last two to three years, and during these periods there will be substantial outperformance.'

The tricky part is the timing: when will investors start to appreciate growth? If the global economy continues to steam along and there is plenty of growth to go around, growth companies may not see much of a premium rating.

'This is why we advise our clients to split their portfolios between growth and value stocks,' says Alliance Bernstein's marketing director Eleanor Seet.

Indeed, investors should not ignore growth stocks. Just having one and riding with it can do wonders for a portfolio.

And you need not look far for a growth company. On the Singapore Exchange, $10,000 invested in Cosco five years ago is worth $1.1 million today.

The same amount invested in Raffles Education during its IPO in January 2002 is also worth about that sum today. It's worth more if you reinvested the dividends back into the stock. The same amount invested in Google just two years ago is now worth $73,000.

Of course, you have to be vigilant when it comes to growth investing. As Mr Pang says, the biggest risk is over-staying.

But one stock like Cosco or Raffles Education will make up for the many that will disappoint.

For the benefit of readers who wonder what are the growth stocks on the Singapore Exchange and their valuations, I obtained a sample list from Bloomberg.

The writer is a CFA charterholder. She can be reached at hooiling@sph.com.sg