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September 25, 2006

Debating Growth and Value

Last week on Real Money, there was a debate on the growth vs. value question. It began when my colleague, Ed Stavetski asked, “As the economy slows and earnings growth tails off, does one want to own value or growth?” Ed asked the question after reviewing year-to-date returns for the Russell growth and value indices that show a big edge for value (this edge was captured by Northlake’s Style model which flashed a value signal from February through August). His conclusion appeared to be that the market had spoken and a slowing economy was rewarding value.

Another colleague, Gary Dvorchak, jumped into the debate the next day looking at valuation of growth vs. value. He showed some charts indicating that growth is close to an all-time low on a relative value basis vs. value. Obviously, his conclusion was that growth is now the place to be.

Northlake’s model, courtesy of Ned Davis Research, offers a similar split decision but did shift to a weak growth signal this month. The shift follows a summer that started with just three of the nine factors favoring growth. Entering fall, there are now five on nine factors favoring growth. That is barely enough to shift the signal, but it shifted nonetheless.....

Northlake’s model includes both of the factors that Ed and Gary mentioned. While I agree with Gary’s view that growth is cheap, I take issue with Ed’s view that a slowing economy favors value. I think a slowing economy favors growth. Here is a chart that shows the performance of growth vs. value based on whether coincident indicators are rising or falling on a year-over-year basis:

Download Growth vs. Value and Coincident Indicators

It might be hard to read but based on this data going back to 1979 when the 12 month rate of change for the coincident indicators has been below 0%, the Russell 3000 Growth has returned 16.1% annualized while the Russell 3000 Value has risen at an annual rate of just 7.3%. Intuitively, this makes sense to me. Growth is more valuable when the economy is decelerating because growth companies don’t need the economy to produce positive year-over-comparisons in revenues, operating income, earnings, and cash flow. When data lines up with common sense, I fell pretty strongly that the thesis makes sense.

Looking at valuation, as I noted, Gary is correct that growth is looking cheap at the moment. However, at least based on this measure of relative forward P-E rations for the Russell 3000 Growth and value indices, growth is not yet really cheap on a historical basis:

Download Growth vs. Value Comparative Price-Earnings Ratios

Now I’ll admit that I might be cherry picking data here to support my positions. For example, Gary showed a chart that indicated that on price-to-cash flow basis growth is cheaper than value for the first time in at least 30 years. I am sure that Ed can probably offer a chart that shows that the current economic environment, albeit slower growth than it was a year ago, favors value.

The bottom line, however, is that after five plus years of value or growth when the predictive factors all lined up largely in favor of value, many of those same indicators are now suggesting growth. Northlake’s Style model made the switch. We shall see if the call is accurate and whether it proves sustainable by recurring next month and beyond.

Posted by Steve Birenberg at September 25, 2006 12:02 PM in Models