Are Growth Stock Prices Reflecting a Cheery Consensus?

In one of his chairman's letters, Warren Buffett once stated that ...

"The future is never clear, you pay a very high price in the stock market for a cheery consensus."

I just looked at the 10 year returns of the Russell 1000 Value Index, and the Russell 1000 Growth Index.

Frightening, the cost of a cheery consensus, particularly those orienting towards the growth side of the equation.

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The difference in the current valuation metrics on the two indices are significant, scary, and points to, may I suggest, more of the same looking forward.



JW

The Confused Capitalist

Value matters: Low PE stock returns pummel market averages!

If you needed more evidence or confirmation that stock value matters, i.e. not paying too high a PE ratio for stocks, some late-breaking research confirms, once again, that "value" stocks beat up on expensive "growth" stocks.

A report recently released by RBC Dominion Securities confirmed that a portfolio of the cheapest 20% of the equity universe has, since 1980, far outpaced the rest of the market. This performance contrasts even more markedly with the most expensive 20% of the market.

Total returns for those one-fifth of companies with the lowest price-earnings ratios in the S&P500 beat the index by 3.5% annually, and trampled the 20% most expensive part of that same market by 6% annually.

In Canada, the example was even more extreme, with the S&P/TSX composite index used as the equity universe. There, the cheapest one-fifth of companies soared past the index by 5% per annum, and trashed the most expensive quintile of companies, by 15% annually.

Furthermore, this performance is remarkably consistent over time: every five year period over that time frame saw the cheaper stocks outperform, except for a single five year period (the bubble years of 1995-1999 and only within the S&P500), and even then, this was only minor and only against the most expensive quintile of stocks.

Perhaps this can form the basis for a new "enhanced ETF" product.


JW

The Confused Capitalist

A tale of two cities (stocks): Value Investing

Perhaps I should subtitle this posting: why it pays to be a so-called Value Investor.

"Value Investing" isn't about trying to find a cheap used cigar, as it has sometimes been put. It's about trying to find a stock that seems economically-priced, relative to it's own earnings/balance sheet/revenue, i.e. its own prospects, and that also seems cheaply priced by the market, relative to competitors and even the broader market.

Companies that perform very well often become stocks that are 'priced for perfection', and hence subject to a fall. Which brings me to today's tale. About three years ago, I talked to several of my friends and colleagues about sub-prime mortgage lender Home Capital Group, on the TSX exchange as "HCG". I just loved the prospects of that stock; growing it's earnings at about 30-40% annually, and a PE ratio of about 15 or so. Great balance sheet, very low defaults - believe me, there wasn't much not to love. I bought a bunch and was quite happy with my gains as they unfolded.

However, I later sold out of the stock - it was still a great company, but it's PE kept expanding faster than it's earnings to the point where it was priced (at one point), at a PE of about 30 or so. In pretty short order, it went from $15 to nearly $40.

Readers here know that I generally don't like stocks with mind-bending PE ratios, and so I sold out my shares. With some of the proceeds I invested into a similar situation, the sub-prime lender, Xceed Mortgage Corporation (XMC). A very nice PE, below 10, similar very high earnings growth rate to HCG; not much not to like. It's gone from $4.50 or so, to recently over $10. And with a modest PE expansion to about 13.

Which brings me to Tuesday's news relating to Home Capital - they warned that earnings growth was slowing, but felt they may be able to make their long-time annual target of 20% EPS growth. And now why I don't like stocks "priced to perfection" - over the past two days, Home Capital has lost 23% of it's value, bringing it's PE down from 23 to 17.

Xceed? Well, the stock "fell in sympathy" as they say, but only by 7%. And the major reason for that is the much more reasonable PE - 13 or so. So the PE fell to just under 12. I'm sure that whatever the situation is as it unfolds for Xceed and Home Capital, and others in the sub-prime lending group, that my investment is better protected in the "value investment".

Value Investing: not just your father's investing!


JW

The Confused Capitalist