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High-Growth or Value?

There is a long-term dispute between value and high-growth investors as to which strategy delivers the best returns. One money manager following the CAN SLIM high-growth investing tactics of William J. O’Neil (NorthCoast CAN SLIM Private Clients) claims an annual return of 25.3% from Jan 2001 – June 2010. Warren Buffett, a famous value investor, reports a compounded annual gain of 20.3% from 1965 – 2009.

Granted, in both categories of value and high-growth investing, investors like to perform their own flavor of analysis to increase the odds of finding a highly profitable stock. But when dealing with averages over very long periods of time, it would appear that value investing has the edge. In a 1994 paper by Lakonishok, Schleifer and Vishny, value investing outperformed the "glamour" or high-growth investing by 10-11% on average between 1963 and 1990 on the AMEX and NYSE.

What are some possible reasons for value investing outperforming high-growth investing in these studies? The 1994 paper offered the explanation that investors may have too lofty expectations from high-growth stocks that did not correspond to realized future earnings. Also, value stock picking as calculated by low P/E ratios was not measured to have higher risk associated with the higher returns when compared to high P/E stocks. Of course, the lowest risk were average P/E ratios, but these were not studied.

Improving Value Stock Picking With Long-Term P/E Ratios

A further case study in the U.K. separated high-growth and value stock returns for the years 1975 – 2003. (Anderson, Keith P. and Brooks, Chris, The Long-Term Price-Earnings Ratio-May 2005). Granted, this is in the U.K. and its results are unproven (to the best of my knowledge) in U.S. markets. But the findings were that by using the average of a trailing P/E ratio and one from eight years ago, value investing profitability greatly increased. If the average P/E ratio was low in both instances, then forward profits increased as opposed to a current low P/E but an extremely high P/E 8 years ago.

To create a simple value investing stock selection that follows in the footsteps of these two research papers we will do the following:

  • Trailing P/E ratios under 11
  • 5 year average P/E ratios under 15
  • Market Cap over 2 billion
  • AMEX, NASDAQ, and NYSE markets only
  • Low combined average P/E of last year plus 8 years ago

The Out-of-favor List of Stocks

  1. DST Systems (NYSE:DST)
  2. Edison International (NYSE:EIX)
  3. Endurance Specialty (NYSE:ENH)
  4. Seacor (NYSE:CKH)
  5. Telecomunicacoes de Sao Paulo (NYSE:TSP)
  6. Torchmark (NYSE:TMK)
  7. UBS (NYSE:UBS)
  8. W. R. Berkley (NYSE:WRB)
  9. Western Digital (NASDAQ:WDC)

Interesting Features

Another point of interest in this basket of stocks is the rolling EPS over the past decade and comparing it to the P/E ratio.

  • On DST, the EPS has steadily inclined from 1.82 to 5.92. Yet, the P/E ratio has dropped from 27 to 8 and the price is still down over 30% from Jan 2001.
  • TSP has seen declining P/E ratios over the past eight years, steadily increasing EPS, yet prices are trading at same levels of six years ago.
  • TMK is a similar story with prices trading close to 7 year ago values, steadily dropping P/E ratios with rolling EPS on the incline over the past 10 years with the exception of a small dip during the recession.
  • UBS is another story. The EPS took a massive hit during the recession and current EPS is reaching eight-year ago levels. Since bottoming out in 2008 the earnings have dug themselves out of a hole. Still, the decline of share value from $57 down to $7 and back to sub 20 bucks has given this stock a wild ride.
  • WDC is another classic example of falling P/E ratios, long-term rising of EPS and a volatile, but up-trending share price.

Trying to adapt P/E theory to actual value stock picking is one approach to value investing that has historically proved useful in creating larger gains than "glamour" stocks. However, we will definitely return next year to see what the actual gains are on these out-of-favor stock market picks. One aspect I did not consider on this list was the short-ratio (21 high short-ratio stocks picks here), which could create a strong momentum once a turn-around begins.

Note: Even though this article discusses the benefits of value investing, I am also a high-growth investor that believes in careful stock selection of highly speculative companies such as this list of micro-caps.

Source: Nine Unloved Value Stocks That Could Vastly Outperform the Market