Seeking Value? Look For Growth

4/28/2014


A fierce sell-off in the most richly valued growth stocks has triggered a flight to safety, helping the consumer-staples and utility sectors rank among the market's leaders since the end of February. Also benefiting have been value stocks, with the Russell 3000 Value Index gaining 2.2% since Feb. 28 and the Russell 3000 Growth Index slumping 1.8%.

While our portfolios tend to outperform when quality and value are in favor, I'd advise against a wholesale shift into the most defensive names or the absolute cheapest stocks. Among my reasons:

Defensive names are not cheap. The consumer staples and utility sectors trade at below-average price/earnings ratios. But both are among the more expensive sectors relative to their own historical norms, and both are quite expensive relative to expected profit growth. In fact, the defensive staples, utility, and telecom sectors rank worst among the 10 sectors based on average PEG (P/E to expected five-year profit growth rate) ratio.

Even cheap names are not cheap. While the very highest flyers in biotechnology and internet commerce have borne the brunt of recent selling, the market's valuation problem is not limited to such extreme examples. The cheapest one-fifth of S&P 1500 stocks trades at a median trailing P/E of 12.8 — above the norm of 10.6 for the cheapest quintile since 1994. As shown in the table below, the cheapest stocks are more expensive relative to historical norms than the most expensive quintile. For the S&P 1500, the cheapest quintile's median P/E is higher than it was on more than 92% of month-ends since December 1994.

EVEN CHEAP STOCKS ARE EXPENSIVE
---------------------- Trailing Price/Earnings Ratios ----------------------
------ Full Set ------
Cheapest
------ Quintile
------
Most Expensive
------- Quintile -------
Mean
Median
Mean
Median
Mean
Median
S&P 1500 stocks
Recent P/E
23.2
20.4
12.3
12.8
41.2
37.5
Norm since Dec. 1994
21.1
17.9
10.1
10.6
40.0
36.0
Minimum since Dec. 1994
12.4
10.2
4.4
4.7
25.8
22.0
Maximum since Dec. 1994
26.4
23.1
13.2
13.8
48.0
44.8
% of month-ends
since Dec. '94 with
P/E lower than recent
85.3
91.3
94.3
92.2
64.2
65.5
S&P 500 stocks
Recent P/E
21.1
19.4
11.7
12.0
35.8
30.8
Norm since Dec. 1994
20.7
18.0
10.2
10.7
38.2
34.4
Minimum since Dec. 1994
11.1
9.6
4.7
5.0
21.6
17.8
Maximum since Dec. 1994
27.6
24.6
13.8
14.9
50.1
49.0
% of month-ends
since Dec. '94 with
P/E lower than recent
59.0
76.2
88.3
84.0
37.0
28.8

Growth and value are joined at the hip. Some of today's best values can be found among companies with solid but not fabulous growth prospects. In an environment where cheap stocks and rapid growers are scarce, looking for attractively valued growers makes sense. The PEG ratio has been among the most effective Quadrix variables over the past year, and the 15 PEG plays listed in Value Focus represent a nice shopping list.

Value-only strategies can be volatile. Historically, simply buying the cheapest stocks has been a winning proposition. But such a strategy requires broad diversification — and a tolerance for wide price swings. For stocks in the broad Dow Jones U.S. Index, the cheapest one-fifth of stocks based on Quadrix Value scores delivered an average 12-month return of 17.1% since 1992, versus 13.4% for all stocks and 16.0% for the top one-fifth on Quadrix Overall.

OVERALL LEADERS VERSUS VALUE LEADERS
Numbers below are based on 12-month returns for Dow Jones U.S. Index stocks since December 1992.
All Stocks
In Index
Top Quintile
On Overall
Top Quintile
On Value
Average 12-month return
13.4
16.0
17.1
Standard deviation of returns
20.8
19.7
26.2
Average return/standard deviation
0.64
0.81
0.65
Geometric mean return
11.4
14.7
14.3
% of positive 12-month periods
78
83
78

The Value standouts were volatile, with a standard deviation one-third higher than the Overall leaders. Based on return per unit of risk, Overall came out ahead. The Value standouts delivered positive returns in 78% of 12-month periods, below the 83% of Overall leaders.

Conclusion

Investors tend to gravitate toward what's in increasingly short supply, and the number of stocks with low PEG ratios has been dropping steadily since November 2011. While low-PEG stocks have enjoyed strong returns over the past year, I still think a growth-at-a-good-price approach makes sense for the year ahead.

More than PEG ratios, I'm looking for stocks that score well based on Quadrix Overall, which takes a more sophisticated approach to highlighting attractively valued shares of fundamentally superior companies. Especially attractive growers include Alaska Air Group ($94; ALK), Magna International ($101; MGA), SanDisk ($85; SNKD), and United Rentals ($96; URI), all of which have Overall scores of at least 98.


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