From the October 2007 issue of Wealth Manager Web • Subscribe!

October 1, 2007

Yesterday's Battle

The old debate over the relative merits of growth and value is roaring to life again. Investors may be well advised to take note of this latest incarnation, because the market's tectonic plates appear to be shifting. At first glance, it looks like bulls asserting that growth-style stocks are going to surpass value stocks are--finally--going to be correct. Indeed, after value's persistent domination since the tech wreck of 2000, the pendulum finally seems poised to swing back in favor of growth.

As of July 31, the large-cap Russell 1000 Growth Index had notched a total return of 6.45 percent YTD, while the Russell 1000 Value Index was lagging with gains of 1.32 percent--a clear reversal of results during the last several years in which the value index trounced the growth index. The divide becomes even more noticeable in small-cap stocks: The Russell 2000 Growth Index is up 3.65 percent YTD, compared with a loss of 5.04 percent for the comparable value index.

Still, some investors make a compelling case that hopping on the growth surge won't help even the most nimble investor as much as simply seeking out well managed companies with both growth and dividends. So says Alan McFarlane, managing director of Walter Scott & Partners, an Edinburgh-based boutique with $32 billion in assets--including those of many U.S. pension fund clients--under management. "The dichotomy that says 'I'm a growth company, so I pay no income; I pay no dividends; I retain everything,' or 'I'm a cash cow, and I pay it all out' is an absurd dichotomy," McFarlane insists.

But to fully comprehend his viewpoint on stocks, you must first understand McFarlane's thinking on bonds. He believes the robust returns in the U.S. bond market over the last 25 years amounted to an unsustainable bubble, and bonds will soon return to their 100-year average performance of flat to 2 percent returns. Since central bankers managed to tame inflation through lots of hard work in the 1980s, interest rates have fallen sharply, which have pulled down bond yields. So McFarlane reckons investors cannot rely on bond income to account for a healthy chunk of retirement savings. Worse, this change--along with others including increased longevity--has brought about the death of the defined benefit pension plan which, in turn, has left most workers to shoulder the heavy lifting for their own retirement.

"The question changes radically when you suddenly have a cohort of people-- millions of them--who need the income generated from their portfolio," says McFarlane. "And value and growth cease to be the relevant criteria." Those workers, and their advisors, must turn their attention to equities to build their retirement nest egg, he believes.

Specifically, he adds, they should look for stocks in companies that pay dividends. McFarlane points out that from 1900 to 2005, real total returns from U.S. equities were 6.5 percent, but only 2.1 percent of those profits came from capital gains. In his opinion, the real powerhouse of equities over the last century has been the compounding effect of dividends, which provided the other 4.4 percent gain.

"Everybody focuses on share price movements, and over the short term, so they should. But the evidence is compelling that the moment you stretch out beyond the short term, that income-compounding effect is enormous," he says.

Jeremy Siegel, author of the investment classic Stocks for the Long Run, argued the same point in his recent book, The Future For Investors: Why the Tried and the True Triumph Over the Bold and the New.

Siegel says he is still a stock enthusiast, but argues that it's time to set aside the indexing strategies that served investors so well in the bull run of the 1980s and 1990s. Instead, he advocates a more selective process in which investors seek companies that return excess cash to investors through dividends and share buybacks. His data show these stocks tend to outperform those of sexier young companies that plow all their capital back into the company to fund growth.

That would seem to be a ringing endorsement for value stocks over growth stocks. Yet, McFarlane makes an important distinction. He insists that cash cows beloved of many value investors--old-line dividend-paying companies in mature industries with little growth but lots of retained earnings--are not the answer.

"You want to invest in companies that are retaining money in the balance sheet to grow the business, but are paying a growing dividend: a true growth stock. You want to invest in companies that grow their earnings and grow their dividends--not by financial engineering, but by actually being better year in, year out."

As exhibit A, he cites Japan's Canon. McFarlane has indexed the company's results back to 1995. In that year, Canon's return on equity was 6.5 percent, and it had 11 percent in debt. This, he adds, was in the midst of Japan's economic malaise: "Many of Japan's really good companies said, 'We're not waiting for the government to fix this. We're going to do it ourselves.'"

Over the next decade, the company's operating profit, operating margin, earnings per share and dividend per share dramatically improved. Over 10 years, a 6 percent compound growth in revenues became a 7 percent compound growth in gross profit. The company invested more in research and development. It notched a 14 percent operating profit, 21 percent earnings per share growth, 23 percent dividend per share growth. Most remarkably, the company still has 36 percent of the balance sheet in cash.

McFarlane notes that there is a difference between his definition of "growth" and its meaning in the U.S. in recent years. "Growth investing as it is put to us often seems to be sunrise industries, rising rapidly with short operating histories: Google bought YouTube; eBay bought Skype. They're all guzzling each other all the time, trying to grow and grow and grow."

He notes that whether or not the companies are generating much cash on the balance sheet, they're not paying out much in dividends. That's because the market's assumption is that all the value is in the retained earnings, so why pay it out? Keep growing, keep going. Now Microsoft is this huge cash cow.

"We're not meaning that by growth," he continues. "What we're meaning is, it is possible to find businesses that just make it a little better every day."

Jeffrey Saut, chief investment strategist at Raymond James, agrees with that assessment, paraphrasing value investing guru Warren Buffett: "What is value if there's not a growth component to it?"

Saut adds: "I think stock selection, be it growth, value or a blend of the two--if the person [doing the] selecting is any good--will always outperform."

And yet, though few will argue with the wisdom of buying good companies, many market players still believe in the power of cycles. "I do think you get these performance runs. I definitely think they matter," says Lincoln Anderson, chief economist and CIO of LPL Financial Services. He believes a swing back to a growth cycle is underway.

As evidence, Anderson cites the slight advantage growth stocks have over value so far this year, saying it marks the start of a growth cycle after many fat years for value stocks.

In fact, in the view of many observers, value's outperformance has become somewhat overdone. From value's absolute bottom in 2000, the Russell 3000 Value Index has beaten the Russell 3000 Growth Index by 110 percent, the biggest margin Anderson has seen in his lengthy career.

Further, he looks at the relative internal performance of the markets now and sees a near-mirror image of 1999, the peak of growth's dominance. Then, the top performers of the previous five or six years had been technology and health care--all large-cap companies. Among the biggest laggards were energy and materials stocks, international stocks, emerging markets, REITs and other value stocks.

Compare that with the picture today. Over the past six years, all of 1999's poor performers have been winners. The top two sectors over most of the last six years were 1999's ugly ducklings: energy and materials.

Anderson believes that today, these classic value sectors are risky because of sharp increases in stock prices, pushed higher by climbing commodities prices. And the recent cooling in that sector does not eliminate that risk. Nevertheless, this is not to say all the pieces are in place for total growth dominance. Anderson admits that another sure sign of growth dominance, a big turn in technology stocks, has yet to materialize. But he adds, "It's finally starting to look like it might do better."

"To say 'Keep your nose down and ignore the macro-environment,' is cruising for a bruising," he says.

Still other market watchers come down somewhere in between the two schools of thought. In October 2005 Lehman Brothers published a report entitled "Large Cap U.S. Equity: Is Style Still in Style?" Analyst Simeon Hyman wrote that style cycles do exist, but that investors had placed "too much emphasis on index-level definitions of style." He argued that they would do much better to take a more "nuanced approach" to the style box, focusing on the extremes: bottom-fishing value and shoot-the-lights-out growth.

The report went on to outline differing definitions of growth and value stocks by rival indices, whether purely identified by price-to-book ratios (S&P Barra) or price-to-book valuations combined with growth rates (Russell). The problem with both, it said, is that it is the extremes of each category that are the most important factors determining performance. "The highest multiple extreme growth stocks and the lowest multiple deep value stocks drive style performance distinctions," Hyman wrote.

Other variables also influence performance, including sectors, which have their own style cycles. Notable examples include technology and health care, among the top performers of the late 1990s and the least inspiring in the past six years.

The report also diagrammed the shape of style cycles. Generally, style cycles show "near-term momentum," meaning odds are good that whichever style was working most recently will continue to work, until an inflection point-- which, unfortunately for investors, is usually pretty sharp.

But there are key differences between the behavior of the two styles. Value stocks tend to beat the market most soundly at the beginning of a value cycle--as in 2000. Growth stocks tend to do so at the end of a growth cycle--see 1999. Hyman advocates viewing the two cycles as one complete market cycle, starting with value's dominance.

So the cycle begins with value drubbing growth. Then value stocks get expensive, and their valuations move closer to that of growth stocks. Then growth's relative performance improves. Investors' enthusiasm for growth gains momentum, and value stocks become cheaper. By the end of the cycle, value stocks are very cheap, and growth is very expensive. When investors decide the valuations are out of touch with reality, and value stages a sharp rebound, the cycle starts over.

Given all this, Hyman dispenses commonsense advice for switching allocations: Be leisurely when shifting from value to growth, since the change from value dominance to growth is usually gradual. But be nimble when switching out of growth into value. And because of the sharp downturns in growth, get out of those stocks early, "even if it means leaving a bit of growth money on the table."

Lately, some value investors have seen their chance to shift into some of those growth stocks, whether it is early in a growth cycle or not.

Back in November, Whitney Tilson, the editor of the "Value Investor Insight" newsletter and co-founder of the Value Investing Congress, highlighted what he called a rare opportunity for value investors--the chance to buy former large-cap growth darlings like Microsoft, Dell, Home Depot and Wal-Mart on the cheap. In his column for the Financial Times, he wrote that the sweetheart opportunity arose thanks to large-cap growth's five years of being in the doghouse with investors.

Like Siegel and Anderson, Tilson, highlighted the importance of multiples. Despite growing earnings at these companies, their share prices sank when their multiples compressed post-bubble as investors cheered other parts of the market, including real estate and commodities.

Tilson also dismissed naysayers who warned that the recent popularity of large-cap growth stocks had been a flash in the pan. He cited analysis by Rich Pzena of Pzena Asset Management, which identified eight periods of growth and value dominance since the beginning of 1969: Four for growth as embodied in the S&P 500, and four for value, defined as the 200 stocks of the largest 1,000 with the lowest price-to-book ratios.

Pzena made some intriguing observations, most notably that growth cycles averaged a lifespan of 37 months, while value was in the sun for an average of 76 months. And in fact, 76 months from the start of value's dominance in March 2000 was the summer of 2006--about the time large-cap growth stocks started to outperform traditional low price-to-book stocks.

And yet, given these clear signs that some of the world's best-known companies have been selling on the cheap, Tilson did not advocate that readers jump on the growth bandwagon. He closed the column with this: "Are growth stocks due to outperform for another two or three years? I don't know and, as a bottoms-up stock picker, I don't really care. But value investors such as me continue to see more 'value' today in stocks that have traditionally been characterised as 'growth'."

Although he is clearly taking note of the style cycles, Tilson's focus on buying well-managed companies puts him squarely in McFarlane and Saut's camp.

Perhaps that nuanced view can be the "third way" of investing.

Elizabeth Wine is a New York-based freelance writer specializing in business and finance.

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