Value is not a term that is discussed around the water cooler amongst
aggressive growth investors too often, but the concept should not be
totally ignored by them. Aggressive growth investors make the bulk of
their profits by buying stocks with superior earnings growth that
consistently trounce earnings estimates. This is great as long as the
company continues to deliver stellar profit growth and keeps raising
the bar going forward.
But value is important to gauge the
level of investor expectations imbedded in the stock, as well as how
far a growth stock could potentially fall if it slips up. In other
words, value injects a dose of reality into the equation. So what are
some strategies and metrics to incorporate value into aggressive growth
investing?
GARP Investing
Is the value-conscious growth investor
out of luck? The answer is a resounding no. GARP, or growth at a
reasonable price, is a combination of both value and growth investing:
it looks for companies that are somewhat undervalued and have solid
sustainable growth potential. The criteria which GARP investors look
for in a company fall in between those sought by the value and growth
investors. Strong earnings growth is still of utmost importance, but at
the same time valuation matters.
GARP investors do not simply
buy a portfolio with an equal amount of growth and value stocks. Each
stock has to have characteristics of both to qualify.
One of
the best known GARP investors was Peter Lynch, who has written several
popular books, including "One Up on Wall Street" and "Learn to Earn",
and in the late 1990s and early 2000. He is a Wall Street legend due to
his 29% average annual return over a 13-year stretch from 1977-1990 as
manager of the Fidelity Magellan fund.
PEG Trumps P/E
It is common practice for investors to
use the price-to-earnings ratio (P/E ratio) to determine if a company
is over or undervalued. However, the PEG ratio is much more relevant to
aggressive growth investors. This ratio takes long-term earnings growth
rates into consideration, which is vital to the growth investor.
For
example, a stock trading at 20x earnings with a 10% growth rate is much
less desirable than a similarly valued stock with a 30% growth rate.
Here is a brief snapshot of two hypothetical stocks with these growth
rates after five years:
| Stock A (10% Growth) |
Stock B (30% Growth) |
| $1.00 |
$1.00 |
| $1.10 |
$1.30 |
| $1.21 |
$1.69 |
| $1.33 |
$2.20 |
| $1.46 |
$2.86 |
As you can see, Stock Bs
earnings per share is almost double that of Stock Bs after five years.
Clearly, Stock B was the better buy, even though both stocks had
identical P/Es to begin with.
Lowest PEG Not Always Desirable
As with everything in
investing, there are no hard and fast rules with investing. PEG ratios
that are too low can actually be riskier than higher ones. Often times,
analysts over-estimate the long-term growth rates of many growth
stocks, which artificially lowers the PEG ratio. Analysts routinely
forecast 35%+ growth for as far as the eye can see, but studies have
shown that few companies can sustain this level of growth for too long.
So what should the PEG ratio be?
Ideal PEG Between 0.8 and 1.8
Common wisdom says that
1.0 is the ideal PEG ratio, but reality doesnt quite measure up to
that. The S&P 500 sports a PEG of about 1.5. Anything above 1.8 is
probably overvalued, while abnormally low ratios carry their own set of
risks. As mentioned above, beware of overly rosy analyst predictions of
indefinite hyper-growth. Unrealistic expectations are usually priced
into those stocks and they can fall hard when these companies
inevitably fail to meet these expectations. Take the case of one of the
former internet highfliers, Ebay.
The Example of Ebay
Ebay was a universally loved stock
that analysts predicted would grow their earnings over 40% for years to
come. This made the stocks PEG ratio look artificially respectable at
about 1.6, but reality was introduced into the equation when the
company failed to beat the high bar. For the quarter ended 12/04, Ebay
merely met estimates and the stock plummeted from $51.53 to $41.67 per
share, and this was after they met estimates! The point is to beware
35%+ growth projections that never end.
