Why the “value” and “growth” share classes don’t make sense
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As the world moves towards the after-COVID era, money has shifted from growth to value stocks.
To demonstrate this, the S & P / ASX all technologies index (ASX: XTX) lost more than 12% of its 52 week high. Meanwhile, the S & P / ASX 200 Index (ASX: XJO) has hit new all-time highs in recent weeks, rising more than 10% since the start of 2021.
The wisdom seems to be that as the economy recovers from the pandemic malaise, inflation will rise. Higher inflation can lead to higher interest rates, which is anathema to growth stocks that depend on future earnings.
But Montgomery Investments chief investment officer Roger Montgomery rejects traditional categorizations of “value” and “growth.”
“The conventionally accepted method of classifying value and growth stocks is subjective, arbitrary and designed for convenience,” he said in a corporate white paper.
How the definitions of “value” and “growth” are wrong
Value and growth classifications are often made on a company’s price-to-earnings (PE) ratio. Sometimes analysts use the price-to-sales ratio to better reflect fast-growing companies that don’t yet have huge profits.
Growth stocks tend to have high ratios and value stocks tend to have low ratios.
REA Group Limited (ASX: REA) is one example. The online real estate advertising company’s PE ratio is now above 158 after the stock price fell from less than $ 10 eleven years ago to $ 166.70 after market closed on Tuesday.
Even though bank stocks have rallied over the past 6 months, a value stock like National Australia Bank Ltd (ASX: NAB) is still selling at a PE ratio of just 20.5 at the time of writing.
And the growth story of 2020, electric car maker Tesla Inc (NASDAQ: TSLA) is currently trading at a PE ratio above 608.
According to Montgomery, this is a problem.
“Ranking growth and value stocks only on the PE ratio or some other market multiple is flawed,” he said.
“Stocks with high PE ratios can be valuable stocks and stocks with low PE ratios can be for very good reason.”
Stocks with massive PE ratios can also be ‘cheap’
Forager Funds chief investment officer Steve Johnson shared Montgomery’s unease with these traditional definitions last month.
The problem is multiple price calculations don’t tell investors anything on the future potential of a company.
“‘Rocket to the Moon’ is trading at 40 times earnings, so it’s expensive: it’s a lazy conclusion,” Johnson wrote on Livewire.
“And that can be very wrong.”
Johnson said that a business that continues to grow for many years can make current judgments about the PE ratio absurd.
This is yet another investment lesson in the impact of composition.
“When a company compounds its profits exponentially, the fair value can be a seemingly absurdly high multiple of the profits at the start of the year,” he said.
Cochlear Limited (ASX: COH) is an example Johnson cited, admitting he dismissed it years ago due to its high PE ratio.
Two decades ago, the stock was going around $ 35- $ 40, which means a PE ratio of over 30. According to Johnson, Cochlear has risen 15% a year since then.
The stock closed at $ 232.75 on Tuesday.
“Looking back, you could have paid 150 times your profits and still generated an annual return of 10% (including dividends).”