FOOL ON THE HILL
An Investment Opinion

Is There Any Value in Value?

By Warren Gump (TMF Gump)
September 7, 1999

The continuing market dominance of rapid-growth stocks like Cisco Systems <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CSCO)") else Response.Write("(Nasdaq: CSCO)") end if %>, Sun Microsystems <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: SUNW)") else Response.Write("(Nasdaq: SUNW)") end if %>, and America Online <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: AOL)") else Response.Write("(NYSE: AOL)") end if %> has made investors seeking traditional value stocks with relatively low Price/Earnings (P/E), Price/Book (P/B), or Enterprise Value/Cash Flow (EV/CF) ratios, looks anachronistic. The market darlings mentioned above have continued outperforming most stocks in the overall market by far, despite their valuation metrics being stratospheric. While those stocks have continued surging, many of the companies having much lower valuation levels have risen much less significantly (or even fallen).

An investor with a value bent has got to really begin questioning allocating any of her money to value stocks after the dismal performance of the past few years. Four years ago, investors at large might have accepted the premise that growth stocks were in favor, but at some point value stocks would come back in vogue. After all, stock market history is replete with examples where such shifts occur. Now, however, belief in style rotation is starting to wane because value stocks have been out of favor for such a long time.

The S&P 500/Barra Growth Index, a measure of the performance of the growth stocks in the Standard & Poors (S&P) 500 Index, has continued to trounce the S&P 500/Barra Value Index. Since November 1995, the S&P 500 growth stocks returned an annualized 30% each year, while the S&P 500 value stocks provided 20% annual returns. This return disparity has continued over the past year, as the S&P 500 growth stocks returned 39% and value stocks increased 29%.

After such persistent underperformance, it's easy to throw in the towel and assume that value stocks and value investing are historical anomalies. Why should I be investing in a strategy that has been returning 10 percentage points less per year than another one?

Before answering that question, it should be remembered that stocks represent ownership in a company. Contrary to recent popular belief, they are not designed to be lottery tickets, where random luck provides immediate and substantial gains. They are issued to raise money that company management can invest in order to make more money. When you buy a share of stock, you are becoming a partner with all of the other people who have invested money and believe that the company can profitably execute its business strategy.

Many of the stocks with the highest multiples are those that have the brightest prospects. Since these companies tend to lie in market segments with favorable positioning, they have a propensity to issue upbeat earnings announcements and positive developments. The more often this good news emerges, the higher its stock price rises relative to earnings as investors become more confident that the good times will continue. Instead of paying a market multiple of 28x current year earnings for Microsoft <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MSFT)") else Response.Write("(Nasdaq: MSFT)") end if %>, they are willing to pay 61x because of its stunning track record and their belief that earnings growth will continue at strong rates.

On the other hand, value stocks tend to be those companies that have been knocked down due to management missteps, changing business environments, or unsound financial structures. Many of these companies have recently issued bad news or are not experiencing the earnings growth that investors used to expect. Some companies fall into the value segment simply because not too many people are aware of them.

In the former category of the beaten and downtrodden stocks are the likes of CBRL Group <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CBRL)") else Response.Write("(Nasdaq: CBRL)") end if %>, which is experiencing plunging earnings as its core Cracker Barrel chain suffers from management turnover and falling sales. Right now, CBRL is trading at 13x earnings estimates for calendar 1999 because investors are afraid that the company won't be able to turn around its restaurants and earnings might fall further. After lowering earnings expectations for each of the last three quarters, investors are (justifiably) apprehensive about partnering with the CBRL team right now.

One issue that investors in high-flying growth stocks face is the fact that most of the value in their company is based on future expectations rather than current reality. Every dollar invested in CBRL will provide about 7.6 cents in current-year earnings. On the other hand, each dollar invested in Microsoft will only churn out 1.6 cents. This disparity is caused by differing growth expectations.

Microsoft is expected to grow earnings about 25% per year over the next five years, while CBRL is anticipated to show 15% annual increases. Lowering the CBRL rate to 10% because of its current problems (has it hit bottom? will it turn operations around?), we find that Microsoft's earnings yield would move above CBRL's in 2012 and then rise rapidly thereafter. Looking at the long-term, higher growth will always win out over lower multiple.

High expectations are fine when everything develops as planned, but there is substantial risk if expected growth doesn't materialize. Did you know that six years ago, CBRL was one of the market darlings with expectations of sustainable 20%+ earnings growth? At the time, the company traded for what was a then-stratospheric 40x current-year earnings estimates. As those optimistic forecasts didn't materialize, the stock plunged 59% and moved from the growth-stock universe into ValueLand.

We are in the midst of an extraordinarily long bull market and an extremely buoyant economy that make it easy to expect that successful companies over the past five or ten years will continue their success. If that happens, investors should be well-positioned with their holdings. On the other hand, the earnings multiples between today's "can't miss" stocks and yesterday's failed "can't miss" stocks represent a huge vertical drop that will prove quite painful if today's high expectations aren't met. Such a plunge can be buffered by holding shares of companies that currently generate a reasonable level of earnings and cash flow relative to their stock price.