Stocks are first and foremost growth instruments — a bet on the potential upside. But the best thing I can say for the stock market right now is that it’s deeply undervalued. That has been reason enough for me to tell clients over the past several months to cautiously build up stock positions on dips. According to my quantitative valuation tools, at the bottom in early October stocks were cheaper than they’ve been in at least two decades.
It’s been the first time for quite a while that value investors — exemplified by the classic investment writers , and more recently by investor Warren Buffett — have had some time in the spotlight. According to the teachings of the value school, companies don’t have to have whiz-bang new technologies or brilliant new strategies — they just have to be cheap. In fact it’s almost better if what the company does is rather prosaic. Buffett likes slow-and-steady stalwarts like Coca-Cola and Gillette because it’s easier to pin a value on that kind of company than it is on a moving target like Cisco Systems.
There are a couple of problems with value investing. First, it doesn’t take a genius to tell when companies like Coca-Cola and Gillette are cheap, precisely because their businesses are so easy to understand. That’s why they don’t get cheap very often. So it takes a rip-snorting bear market like the one we’re in now, or the last big bear in the mid-1970s, to get stocks cheap enough to where cheapness alone is a reason for buying them.
That’s where we are now — stocks are that cheap. But that brings us to the second problem with value investing. When you buy stocks because they’re cheap, the profits you can expect to earn are strictly limited to the price gains that result when stocks return to normal valuation. The whole theory of value investing is based on catching the market in a mistake — selling stocks for too little. As soon as the market stops making that mistake, the value investor stops making profits.
Growth investing works in all ways opposite from value investing. The growth investor isn’t concerned with getting a bargain in a sleepy company he understands perfectly. He’s interested in hitching his wagon to a star — he’s willing to pay up to have a chance to find the Holy Grail, a company with unbounded potential to change the world and profit from it: “The Next Microsoft.”
It’s harder to pick companies that have growth potential — and that can actually realize that potential — than it is to pick companies that are just downright cheap. But the good news is that such companies are almost always out there waiting to be discovered, and they have virtually unlimited potential.
For example, in a previous column, I pointed out the growth potential of InVision Technologies a company that makes explosive-detection equipment for airports. Since then, InVision’s business has boomed (no pun intended), and its stock has risen 53.2% — while the Standard & Poor’s 500 index has fallen 10.5% over the same period.
But the bad news is there have probably never been fewer growth opportunities in the market than there are today. A company like InVision is a needle in a haystack. Just a few short years ago the market was a whole stack of needles — growth was everywhere. But no longer.
Since the end of World War II, the average annual growth rate for S&P 500 earnings has been 7.3%. In the boom decade of the 1990s it averaged a glorious 9.5%. But the average earnings-growth rate over the last three years has been a piddling 5.0%. It was easy to be a growth investor for a long time — but it’s tough now when there’s so little growth to invest in.
Investors are an optimistic breed by necessity, but this long-term slowdown in earnings growth has begun to take a serious toll on expectations for the future. The bottom-up consensus forecast among Wall Street analysts for three-to-five-year earnings growth for the S&P has come down from a high of 19.0% in March 2000 — precisely the month of the bull-market peak in both the S&P 500 and the NASDAQ — and has fallen to five-year low of 13.1% today.
And 13.1% as a consensus forecast for the next three years looks pretty rosy compared with the reality of only 5% for the last three years. But don’t let that fool you into thinking that explosive growth is just around the corner — these Wall Street numbers are always scaled high. The important thing about today’s 13.1% expectations isn’t how high they are, but how low they are compared with the 19.0% peak less than three years ago.
The chart below overlays the last 12 years of the consensus three-to-five-year earnings growth forecast for the S&P 500 on the price of the NASDAQ for the same period. You’ll see immediately the startling correlation between the two. Probably your first reaction will be to think that this proves that earnings expectations drive the stock market. Indeed they do, but think twice — the message of this chart might be exactly the opposite.
Remember, this chart shows the consensus earnings forecast for the whole S&P 500 — and the NASDAQ is only a small subset of this. But because it represents the technology sector, the NASDAQ represents the growth engine of the entire economy. When that engine is running on fumes, the engine of growth economy-wide can stall out. I think the way to interpret this chart is to see that, as the health of the technology sector has collapsed, so have hopes for overall growth.
After all, where does growth come from? It doesn’t come from people working longer hours — it comes from people working more productively. And where does productivity come from? Technology. So if you want growth, you need technology.
Right now the overall economy is recovering from recession. But the technology sector isn’t. At all. About the most optimistic thing that’s been said came from IBM Chief Executive Sam Palmisano last Wednesday, when he uttered these inspiring words: “As you travel around the world, you see some encouraging signs that perhaps we have hit bottom or things have flattened out.”
“Flattened out” isn’t exactly growth. And without a revival of growth in the technology sector, the overall economy is doomed to only a tepid recovery. The technology sector is in the tank not only because of its own cyclical dynamics, but also because of the accumulation of several devastating government policy errors over the last five years — deflationary monetary policy from the Fed, overaggressive antitrust activism from the Department of Justice, tangled telecom regulation from Congress and the FCC, and now the criminalization of corporate leadership thanks to the Sarbanes-Oxley Act.
It takes a while to turn policy blunders like that around — and we haven’t even begun to do so. In the meantime, smart investors play the cards they’re dealt as well as they can. And right now that means value investing.
Value investing today means looking for cheap stocks in noncyclical sectors such as consumer staples and health care. It means focusing technology investing on a handful of survivors that can keep body and soul together during the hard times by taking market share from competitors.
For the time being, growth investing is dead.
