Should you be investing in growth stocks or value stocks? While it depends on what you're looking for from your investments, it also goes to the core of who you are as an investor. Here, Philip Durell, investment analyst for Inside Value, lays out his argument for value investing, and then Rick Munarriz, head scout for early adopters in Rule Breakers, takes his turn at the plate. When you're finished reading both sides, visit our Dueling Fools discussion board to tell us what you think.
Before I demolish the idea that Rule Breaker speculating is at all rational for an investor, I should like to add the disclaimer that if the lure of its promises to find the next Microsoft are so strong that you can't resist taking a flutter, then you should at least do it with David Gardner's Rule Breakers team -- in other words, don't try this at home!
The one-string fiddle
Whether it was David Gardner's genius, just pure luck, or a combination of both, where would the old Rule Breakers portfolio be without its investment in AOL? The returns are predicated on the success of a single string, and without it where would that old fiddle be? Can that single success be repeated? Do you really want to risk your hard-earned cash investing in highly overvalued potential Rule Breakers on the premise that it doesn't matter what happens to 90% of your investments as long as 10% go to the moon?
Rule Breakers remind me of Icarus, who thought he could fly like a bird; he flew too close to the sun and came crashing to the ground. The market is littered with such glamour stocks that crashed like Icarus. We could go back to the year 2000 and bubble stocks such as Celera for an example -- down from more than $200 to $13 today. But we don't have to take such a long walk down memory lane. Krispy Kreme Doughnuts (NYSE:KKD) is down from a shade under $50 in August 2003 to $8.72 today. Taser International (NASDAQ:TASR) is down more than 40% in the last three weeks and still sports an astronomical price to earnings ratio (P/E) of 70!
At Inside Value, we know that you can still produce outstanding returns without taking on the unnecessary risk that the Rule Breaker philosophy entails. If you buy Taser today, you are paying $70 for every $1 of earnings. Turning the P/E on its head -- that is, looking at the E/P ratio -- your earnings yield is a measly 1.43%; heck, even an ING Direct savings account will pay you 2.35%. I know Rick Munarriz will tell you all about Taser's earnings growing at 35% per year for the next five years. But consider this: if, and that's a big if, earnings do grow at 35% for five years, Taser needs 2010 earnings now to match the long-term market average P/E of 15. All stocks eventually revert to the mean, and if you are speculating on Taser, that reversion had better be long after 2010!
Using Rick's building analogy, value investors concentrate neither on the floor nor the ceiling but on the whole structure. We start building our investing house at the foundation by looking carefully at a company's financial strength, then the floor in its ability to produce cash flow, then the walls in its ability to keep competitors at bay by its competitive advantages, and finally we look at the ceiling for the catalysts and for potential growth. We like growth, but we like bargains better so we simply won't overpay for growth.
Rick's Apple Computer example is quite illuminating. True, value investors would have been all over Apple and its cash two years ago, but why does Rick think that value investors would have bowed out at the start of 2004? It had risen to only $21 from $15 and was a classic turnaround story with a major catalyst in the iPod, precisely the sort of story that value investors love. Every value investor knows that for turnarounds and cyclicals, the P/E is not a useful measure since the time to invest is often when the P/E is high or even when earnings are negative -- Rule Breakers would have missed it staring at the ceiling while looking for the next Microsoft! Sure, value investors might have got twitchy at more than $40 with a price to free cash flow at 22, but a good value investor will sell out gradually as they know the market is just as irrational on the upswing as it is on the downswing.
The 12-string guitar
I know that a 12-string guitar can make beautiful music, and even if a string or two is broken a musician can still play. The one-string fiddle? Horrible to listen to, and when it breaks, there's no music at all! So let me introduce you to some value strings that you could have played, and I don't need to go back to the mid-'90s or look under rocks to find them:
String 1: Home Depot (NYSE:HD): $20 in February 2003, now $42; up 110%.
String 2: General Dynamics (NYSE:GD): $50 in March 2003, now $101; up 102%.String 3: Altria (formerly Philip Morris) (NYSE:MO): $28 in April 2003, now $63; up 125%.
String 4: MBNA: $12 in March 2003, now $27; up 125%.
String 5: MGIC Investment: $35 in March 2003, now $66; up 88%.
String 6: Limited Brands (NYSE:LTD): $11 in February 2003, now $22; up 100%.
String 7: Fairfax Financial: $47 in March 2003, now $163; up 246%.
String 8: School Specialty (NASDAQ:SCHS): $17 in April 2003, now $38; up 123%.
String 9: Rothmans Inc.: C$13 in April 2000, now C$40; up 207%.
String 10: Kingsway Financial: $9 in October 2003, now $15.50; up 72%.
String 11: First American: $25 in July 2004, now $36; up 44%.
String 12: MCI Inc. (NASDAQ:MCIP): $12.50 in June 2004, now $19; up 52%.
Before Rick accuses me of cherry-picking, I should say that I've played every one of these 12 strings. The real beauty here is that you didn't have to come close to the bottom (or buy everything in spring 2003) to make money, a lot of money. Even better, you can learn to do it for yourself, and I invite you to take a free trial of Inside Value to find out how.
More than a single instrument
In study after study, value investing is proven to outperform growth investing over time and that the high risk involved in high multiple growth stocks results in, well, high risk, but not high reward. First, let's look at what Ibbotson Associates, the king of market data and analysis, has to say. Using data from 1926 through 2002, Ibbotson found that growth investing returned a compound growth of 9.2%, whilst the S&P 500 returned 10.4%. Value investing trumped both returning 12.4%!
Looking for more recent comparisons? In 1994, Lakonishok, Shleifer, and Vishny (collectively, LSV) checked out 1968 to 1994 and found that value kicked growth's butt by an outstanding 10%, 19.8% to 9.3%. More recently, the Brandes Institute updated LSV's study to include 1968 through to 2003 and came up with the same conclusions, but added this: The average annualized five-year return was 19% for value and 9% for growth.
Do you want to play a one-string fiddle or a 12-string guitar? Do you want the proven out-performance of Value over Growth? Do you want to invest or speculate? The choice is yours, but even if you decide that Rule Breaking is your style, I invite you to a free, no obligation trial of Inside Value, because even I'll admit that the combination of Inside Value and Rule Breakers may be an excellent diversification for your portfolio.
Philip Durell is the analyst for the Motley Fool Inside Value newsletter. He owns shares in Rothmans Inc. The Motley Fool is investors writing for investors.
