Has Value Vanquished Growth?

With the economy at a crawl, undervalued companies look like the best bet

Today's equity market is to value investors what the Emperor Constantine was to early Christians--a long-awaited vindicator of their beliefs. So far in 2001, value stocks have handily outperformed growth stocks. The Standard & Poor's 500/Barra Growth index has fallen 12.3%, while the S&P 500/Barra Value index is down 4.6%. Mid- and small-cap value stocks have fared even better. The S&P MidCap 400/Barra Value index has gained 3.1% since January, against a 7.5% loss on the growth index. The S&P SmallCap 600/Barra Value index beat its growth peers by a wider margin, rising 6.8%, vs a 7.2% fall.

Does this mean that the gospel of value investing has finally vanquished the creed of growth so popular during the dot-com frenzy? Unlikely. Even though current conditions favor value investing, and will probably continue to do so for some time, growth will rise again once a strong recovery in company earnings changes the market's dynamic.

OPPOSITE ENDS. Through time, the difference between growth and value returns is insignificant. Over the past 10 years, the S&P 500/Barra Value index has yielded a 14.97% annualized return, vs. 14.24% for the S&P 500/Barra Growth index--a minuscule gap of just 0.73%. "The outperformance of one over the other is purely random," says Marci Rossell, chief economist at Oppenheimer Funds. "For the smart investor, both should be part of a diversified investment portfolio." Whether you use growth or value criteria, in a difficult earnings environment like this one it's more important to pay attention to the fundamentals of a company's business than it is to set investment criteria based solely on ratios like price-to-earnings or p-e to sales growth.

The two investing approaches tend to do better at opposite ends of the business cycle. Value outperforms when the cycle is near the bottom--as now--because earnings can't go much lower, and stocks are likely to be undervalued because of an overly pessimistic earnings outlook. Value continues to do well as earnings start to come out of the trough. But growth does better late in the business cycle, when earnings are reaching their peak, and investors are willing to bid up prices to get their hands on the fastest-growing stocks. "Whether you believe the business cycle is nearing the bottom or starting the initial upswing, it's clear we're not at the end of the cycle," says Milton Ezrati, senior economist and strategist at brokerage Lord Abbett, based in Jersey City, N.J.

Even though value is hot, it's too simplistic to say that those investors who bet big wads of cash on tech over the last couple of years should have learned their lesson about growth investing. In fact, all the recent bear market really proved was that tech stocks are not automatically growth stocks, as many investors seem to have wrongly imagined. "Over the last couple of years, growth came to mean tech," says Oppenheimer's Rossell. "In times of normal market behavior, growth and value just represent investing styles, not sectors."

WHAT'S THE POINT? Some analysts argue that the similarity of returns over the long haul makes a strong case for value investing. "You get the same return with value for less gastric juice," says Ezrati. "Growth makes its performance in a very short period, while value makes money every year and protects you on the downside." For investors, that means choosing between a volatile portfolio that swings to dizzying heights in bull markets (as in 1999) or a portfolio that doesn't require daily swills of Maalox because, while it misses out on those highs, it also avoids the lows of a bear market.

Growth devotees don't see much point in being so risk-averse. "If you're more interested in capital preservation than capital appreciation, why not invest in bonds?" asks Peter Trapp, portfolio manager for New York City-based Needham Growth Fund. Trapp is one of a growing school of self-styled GARP investors, who seek out growth at a reasonable price. "I use growth criteria with a value discipline," he says. A pure growth investor would be willing to buy stocks whose p-e ratios were one or more times their annual earnings growth. Trapp looks for stocks whose estimated three-year growth rate is at least double their p-e. "If, over three years, the company's earnings [are projected to] grow at 20%, I'll pay 10 times earnings or less," he adds. "I'll buy a stock that is trading at 20 times earnings, but I have to be convinced it's a 40% grower." That means understanding the fundamentals of a company and not investing unless these are sound. In deference to that principle, Trapp currently has about 22% of his fund in cash.

Value investors' interpretations of the investing style are about as varied as medieval Christians' definitions of their dogma, but if you listen closely, the bottom line is the same as GARP--assessment of fundamentals. In the broadest terms, value investors are looking for companies that trade at less than their real value in the hope that the value will be recognized by other market players and reflected in higher stock prices. To identify such latent value, investors need to examine companies' fundamental business prospects carefully. "You want a company where something is going to change, either externally, like a fundamental change in its industry, or internally, like a change in management," says Chris Leavy, portfolio manager of Oppenheimer Value Fund.

The trick is to focus on qualitative factors. "We have 12 criteria that we use for picking stocks in our portfolios. Nine are quantitative, and three are qualitative. The qualitative ones are the most important," says Nancy Tengler, CEO of San Francisco's Fremont Investment Advisors. "There's the franchise value you get from industry dominance, there's management, and there's the buggy-whip factor--fear of product obsolescence." Those are the same criteria that growth investors worry about when trying to predict growth potential, but unlike the value crowd, they're not put off if a stock is already on a rapid upswing--indeed, many of them prefer to see some strong momentum before they jump in.

Just as value investors must buy stocks that are out of favor, they also have to run counter to market sentiment when the time comes to sell. "That usually happens just when Wall Street upgrades its recommendations," says Tengler. For now, analysts can't downgrade stocks fast enough as company earnings shrink. But once that trend turns and momentum players start raking in the dough, keeping the value faith will be tough.

By Margaret Popper

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