Below is a weekly update from our Chief Investment Officer, Dr. Scott Lummer. He co-hosts a seven minute audio segment entitled “Market Matters.” In this week's show, Scott discusses the differences between growth stocks and value stocks, using Apple as an example. He also explains how investors should allocate between growth and value stocks. Each week he covers a different piece of investment news focusing on recent events in the capital markets, and relates them to Savant Investment Group’s perspective on investing.
Daphne: My name is Daphne O’Neal, and welcome to Market Matters. As always, we will talk about this with the Chief Investment Officer for the Savant Investment Group, Dr. Scott Lummer. Scott, I noticed that since our discussion from last week about Apple, the stock has fallen further.
Scott: Yes it did, but I doubt whether this show had anything to do with it. Apple announced that in the future they expect their growth rate to slow down.
Daphne: Did the market already expect that growth would slow?
Scott: Many analysts predicted a slowdown of growth. However, often analysts and investors believe that an ultra-high growth rate will continue for an unreasonably long time. That is why many stocks have such a high price earnings ratio.
Daphne: You mentioned last week that you thought Apple was a healthy company. But clearly it wasn’t a great investment.
Scott: That is often the case. The value of any investment has to be compared to its price. There is no investment that can perform well if the purchase price is too high. And this is a common phenomenon – well performing companies with high growth rates creating unrealistic expectations, which leads to high purchase prices that cannot possibly be sustained by the fundamentals.
Daphne: I know in the past you were critical of the purchase of the Facebook IPO. Is that for the same reason.
Scott: It’s not just Facebook. The average IPO suffers from overpricing because of unreasonably high expectations. Again, many of these companies are solidly managed – they just have too high of a price. But as we see, its not just IPOs – seasoned stocks like Apple, and even entire industries, can occasionally be overpriced.
Daphne: Why does that happen – wouldn’t investors be concerned about the price they pay?
Scott: In theory, yes. But hyperbole affects markets, and the financial press and various blogs love writing about high growing successful companies. Investors often begin to trample over each other to buy the stock, which drives the price up. As the price is rising, investors who bought earlier rave about their smart purchases, which creates more demand, and all of a sudden fundamentals go out the window. Investors start ignoring factors like the P/E ratio and price to book ratio.
Daphne: How do investors avoid those purchases?
Scott: The simplest rule is if EVERYONE is talking about how great a particular investment is, then it very well might be overhyped and over-priced, and you might want to avoid that investment. A more general rule is always focus on fundamentals. And invest with managers who stress those fundamentals.
Daphne: How do investors find those managers?
Scott: Managers can be classified into two types – growth managers and value managers. As the names suggest, growth managers tend to invest more in stocks with higher growth rates, and focus on growth and profits more than prices. Value managers focus more on the stocks that might be good buys –companies that are not as profitable or growing as fast, indeed companies that might be in difficulty – but yet have relatively low prices so they make good investments.
Daphne: Are you saying that growth managers do not look at price at all, and value managers do not look at growth prospects?
Scott: It’s not that simple – nearly all managers are not purely growth or purely value based. But most managers have tendencies. A manager who buys stocks that have significantly higher than average price-earnings ratios will be considered a growth manager, and a manager who invests in stocks that on average have low price earnings ratios will be considered value.
Daphne: So it seems like you prefer value managers.
Scott: In general, yes I do. Value stocks, historically, have outperformed growth stocks, particularly after considering that growth stocks have been much more volatile than value stocks.
Daphne: Is this concept about differentiating between growth stocks and value stocks new?
Scott: Not at all. Although he didn’t use that label, Benjamin Graham first started writing about this concept in the 1930s. Warren Buffet is probably the best known current practitioner of value investing, and he has been an outspoken believer since the 1970s. In fact, he is such a believer, he gave his son the middle name of Graham.
Daphne: So if value investing provides better results, and everyone knows about it, then why doesn’t everyone follow those same principles.
Scott: It has a lot to do with investor psychology. By definition, a pure value portfolio is entirely comprised of stocks that are in the bottom half, ranked by price-earnings ratio. If you create a value portfolio, the companies you will be investing in will have relatively low earnings, low growth rates, will have less press coverage, and the press coverage they receive will often be negative. When you look at the names, you will ask yourself, where are those exciting companies that I read so much about – where’s Apple, where’s Facebook, where’s Amazon. So most investors start messing with the logic, and creating justifications for adding sexier stocks.
And that pushes them more toward growth stocks.
Daphne: So do you suggest investors only invest with value managers?
Scott: No – because there will be time periods in which value stocks underperform. However, we do suggest investors consider at least tilting their portfolio toward value stocks.
Daphne: Thank you Dr. Lummer, and this concludes this week’s Market Matters broadcast.