Bargain Shopping for Stocks

With all the wailing and gnashing of teeth over the bear market, you would think that stock investors were all losing their shirts. They're not. Value investors have not only avoided the downdraft in share prices, but they have experienced substantial gains over the past year. During the last twelve months, the S&P 500 lost 8.2%. However, if you split the S&P 500 into value and growth components, you'll find that value stocks gained 13.7% while growth stocks fell 25.8% over the same period.

What exactly is value investing? It is really nothing more than finding inexpensive stocks. How can you tell when a stock is cheap? For starters, it has nothing to do with the share price. A better measure is the price-to-earnings (PE) ratio. A stock trading at a lofty PE ratio has a high price tag. Consider Yahoo!, for example. Yahoo! is currently trading at about $16 per share with a PE ratio of 152. When you buy shares of Yahoo!, you are paying $152 for each single dollar of the company's earnings. Although the share price has plummeted from a 52-week high of 187, that is still an expensive stock. In contrast, take a look at Salton, Inc., a leading manufacturer of kitchen appliances. This company is trading at about $15 per share, but at a PE ratio of 3. When you buy shares of Salton, you are paying a paltry $3 for each dollar of company earnings. That's what I mean by an inexpensive stock.

Of course, there is a reason that people are willing to pay up for Yahoo!. As an Internet bellwether, investors expect the company's future earnings to grow rapidly. Hence, its designation as a growth stock. Salton, on the other hand, is unlikely to experience explosive earnings growth any time soon. The market for toasters and waffle makers is pretty well established. Furthermore, value stocks often have a history of recent financial difficulties. In Salton's case, it may have something to do with their agreement to pay George Foreman $113 million for attaching his name to their indoor grills.

So was it just a fluke that value stocks outperformed growth stocks over the past year? After all, buying growth stocks was like printing money in the late 1990s. It turns out that value stocks have generally outperformed growth stocks over long periods of time. From 1964 to 1999, large cap value stocks returned 15.1% annually compared to 11.9% for large cap growth stocks. Small cap value stocks outperformed their growth counterparts by 4.2% over the same time period.

It may seem counterintuitive that financially distressed value stocks should outperform growth stocks. Think of it in terms of the cost of capital. Companies can raise capital by borrowing money or issuing stock. When an individual with a shaky credit history borrows money, the bank charges a higher interest rate. Financially distressed companies also have higher borrowing costs than firms with healthy balance sheets. Why should the stock market be any different? If a financially troubled company decides to raise money by issuing new shares of stock, investors will insist on a higher expected rate of return than they require from a fiscally sound company. This higher expected return is delivered in the form of a lower purchase price for the shares.

What is our point here? Should you invest strictly in downtrodden value stocks and avoid any company with strong growth prospects? Not at all. We favor balanced portfolios that include both value and growth components. The idea is to diversify across investment styles so that you do reasonably well no matter which style is in favor. If you're a patient investor seeking to boost your long-term returns, you might consider tilting your overall portfolio a bit towards value. However, you'll need persistence and discipline to ride out those inevitable periods when value underperforms.

April 1, 2001

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