No Bull: Keep Eye on Value Stocks When the Run Ends

Evan R. Guido Financial Advisor

At the risk of sounding very old fashioned, it's time for a quick primer on two investing philosophies: whether to put money into "growth" stocks or concentrate on "value" stocks.

Growth investors target companies growing faster than their peers and faster than the indexes created to measure overall market and industry growth.

Growth investors like companies that generate substantial top-line growth (revenues) and significant bottom-line profit growth.

Companies that generate quarter to quarter growth year after year typically command the most interest on Wall Street and thus trade at far higher price-to-earnings (P/E) than companies growing at a slower rate.

For example, let's look at two restaurant chains.

One is growing at 25% annually and the other at 5%. Which do you think a growth investor would favor? Obviously, the one with faster growth.

Of course, other factors need consideration including the relationship between top-line and bottom-line growth, and components of that growth. A company generating revenue growth of 40% or 50%, but only generating profit growth of 10% or less may not be as well managed as you would like. Occasionally, investors overlook issues like this, especially early in a growth stock's life cycle. Internet stocks are the most extreme example of this. With them, as long as top-line growth remains consistently strong, the bottom line is not that important.

However, there comes a time in every company's life when revenues begin to slow and bottom line growth becomes more important. Even then, we can look at these companies as growth stocks, as long as there's consistency to the growth. A company growing at 10% quarter-to-quarter (instead of 25% quarterly) is still growing, although not as quickly. Wall Street is likely to consider this when valuing the stock, especially if its competitors are growing faster.

But what happens when the growth stops? What happens when a restaurant chain saturates its market or a software company sells so much of its product that its customer base is tapped?

Depending upon a number of circumstances, we may have a value stock in the making.

Put simply, value investors look for companies with a healthy balance sheet (lots of assets, little if any debt) that may not be growing all that much. Further, Wall Street has taken into account the company's sluggish growth and beaten down its stock price.

A company trading at a low multiple of earnings may deserve that position because its future prospects are questionable. But a company considered a "value play" will trade at a low multiple because Wall Street has not examined its assets and core value close enough to realize there's far more than meets the eye.

Back in the 1980s, the leverage buyout (LBO) craze came in part because Wall Street had neglected a lot of stocks with hidden value. Several textile stocks traded at low multiples because their growth stopped. Yet savvy analysts realized that these companies owned considerable assets that, if valued separately, might be worth a lot more.

Hence the concept of doing an LBO and carving up a company so Wall Street could realize hidden value.

Now, not all LBO's reflected this strategy. But there are dozens of cases in which investors used various strategies to extract hidden value from companies.

Or, value investing often involves putting money in companies with great brands that maybe undergoing a transition or period of sluggishness. Boeing Co. and McDonald's Restaurants have both been viewed as value plays when their shares were trading down.

Obviously, value investing is not big when the market is on a Bull Run. But, as we know all to well, there have been times when Wall Street has turned sour and all stocks, regardless of their future prospects, have gotten clobbered day after day. It's at times like those when value investors have an opportunity to hunt again for companies ready to be "discovered" again.