SIMON BROWN: Don’t peg your hopes on value

I was on air recently with Shane Watkins of All Weather Capital and he made a really great point as we were chatting about growth vs value stocks as investments.

Value stocks are those that are considered cheap and often in older industries with less growth. His view is that while value can be a good investment, the upside is limited. Sure, you may get a value unlock and that could make for a good return. Very nice, but then any upside is largely over if the stock is not in a growth industry. Now it’ll just move along at GDP plus CPI profit growth. In other words, deeply boring and not thrilling for your portfolio in the long term.

Growth stocks, on the other hand, have significant upside as they’re growing in a growth industry, compounding earnings and ultimately the share price. This is where you’ll find those ten-baggers or more, to make a significant improvement in your portfolio.

Yes, growth is not always in a straight line — and even more importantly, you have to pay up for quality growth stocks. They are seldom cheap, unless we are talking about the occasional bear market.

The price:earnings-to-growth (PEG) ratio is a good way to get an idea of the attractiveness of a growth stock. Use the p:e divided by the expected growth in headline earnings for the year ahead. A value below one is cheap; above two is expensive. It’s not perfect but it does help when buying a stock with a very high valuation because a low PEG suggests it will grow into that valuation with increased earnings.

The other risk with value stocks is that you may be buying a value trap. The stock is cheap and probably trading at a juicy discount to NAV. But instead of constantly rising, the price goes nowhere — or worse, continually slips lower. Spotting value traps is not easy. The problems vary from a declining industry to poor management and no real competitive edge. But the easy way to spot them is this: their multiples, such as the p:e, have been low for an extended period, often for years.

Sure, there’s value, but how does it get unlocked? It needs buyers, lots of them. If it’s a small cap, that means private investors need to get excited about the stock — but what’s going to suddenly get them to start buying and sending the price higher?

If it’s a larger stock that institutional investors can buy into, you need something to change for them to get excited and start buying. Selling an operating unit, fresh management or a new area of potential profits are all possibilities. But then why jump in early? Wait for the signs first.

I largely stay away from value, unless there is a chunky and secure dividend. My focus is typically on growth stocks because that’s where we’ll see outsize returns, if we buy the right growth at a decent price.