Let's start off by giving you a few definitions:
Most stock market experts would define a value stock as one that is priced too low when you compare its earnings and book value, per share, to other companies in the same industry. Put another way, its financial strength indicates that the stock price is a bargain. However, not every "value" stock is a good value. Rather than bargain, sometimes it's just half-priced junk.
Companies whose sales and earnings are growing faster than the average are growth companies. Since the company is getting bigger and more profitable, there is increased interest in these companies and investors are willing to pay "too much" for their stock, as evidenced by their higher PE ratios. The marketplace has high expectations for such a company's future, even though it may not yet even be earning a profit. Its exploding sales may have created the expectation of huge profits.
History has shown that investors, at any given time, have a clear preference for either growth or value stocks. It's not that both can't perform in an up market. However, there is typically a very distinct bias to which is doing better on a relative basis. This was particularly obvious over the past decade, when the technology bubble of the late 90s was followed by a strong swing towards stocks that offered cash flow and stability. From 2000 onwards, global investors? inclination for above average dividend yields, low P/Es and strong balance sheets resulted in an impressive partiality to value over growth. Further, with the FED lowering interest rates to forty year lows, many of these debt laden value stocks found their balance sheets improving without their business prospects showing any dramatic improvement. The economic condition simply made these companies more valuable.
While the strong performance of value stocks started as a reaction to the bursting of the dotcom bubble, from 2003 onwards another element, a widespread earnings recovery in sectors categorized as value continued to boost the market. Aggressive cost-cutting drove a strong European earnings recovery against a backdrop of sluggish revenue growth. Globally, strong demand from China led to higher commodity prices and, as a result, contributed to rising profits in cyclical sectors such as resources and steel. On whole, the relative abundance of growth in the value space has diluted the premium investors would traditionally be willing to pay for growth stocks. It's not to say there are no true values in the market anymore. It's simply to say that value companies are now more fairly priced and true value plays are harder to find.
Many analysts believe that 2006 see a "changing of the guard" back toward growth stocks. I've seen this as the biggest topic of discussion for most institutions and several factors hint that the backdrop for this reversal may be in place. First, there are limits to the amount of cost cutting measures that companies can implement. We were in a slight recession in 2001 and corporate America has been cutting the fat ever since. But, once companies have cut costs as much as they can, profit growth will have to be generated by higher unit sales. That said, in an environment of fierce global competition, raising business activity is no easy task. As a consequence, profit growth should decelerate and become relatively scarce for many of our recent value winners. Another sign indicating a growing willingness of investors to pay for growth is the change in attitude towards merger & acquisition activity. Until recently, a company announcing a takeover would see its share price decline as there is typically some level of uncertainty regarding mergers. However, companies are now no longer punished, or in some cases are even rewarded by investors, for their willingness to invest in future growth. As well, the sheer number of mergers we've seen in the last twelve months shows a renewed commitment by company leaders to grow their businesses at any cost. Last, many of the sectors that appear to be taking over leadership in the markets are traditionally thought of as pure growth industries (i.e. tech and telecom).
Given this outlook, growth stocks should command a higher premium based on their higher profit growth, particularly in the context of slowing global earnings growth. This leads us to believe that growth stocks, after a dramatic underperformance versus their value peers in recent years, are well positioned to outperform them in the year ahead. With average global profit growth on a downward trend, investors will be willing to pay a premium for those companies that do offer above average profit growth.
Finally, while we can see a global backdrop for a reemergence of growth at the expense of value, we're not yet seeing the technical action confirming this in the real short-term. Take a look at the chart below. The chart is for the IWF (the Russell 1000 Growth Index). At the top of the chart, we've attached a relative price chart for the IWF versus the IWD (the Russell 1000 Value Index). What this chart is telling you is that growth compared to value is still underperforming. This is why the smoothed line is moving down. It's our belief that, at some point this year, this chart will tell an entirely different story as growth will reemerge in the market. However, as I mentioned earlier, it appears EVERYONE is expecting this shift. As we all know, the masses are usually wrong and technically, the shift has NOT been made to growth yet. You can give me all the justifications in the world as to why growth should outperform, but until the price action confirms this, you can't make the shift until both the fundamental reasons and the technical action aligns to give you a true buy signal. As you can see from the descending trend line on the chart, growth is very close to breaking through on a relative basis (blue circle). If it does, we would be more prone to digging into growth stocks/funds. But, it's not out of the realm of possibility that this relative price chart could have one more dip before it breaks out.