It's among the thorniest of issues in the investment world: At what point does an underperforming style of investment turn appealing?
The style of the moment on this account most certainly is large-cap growth. It has been, bar none, the worst performing mutual fund style over the past five years, but our current position in the economic cycle coupled with the extreme valuation disparity between growth and value suggest fortune may soon shine on large-cap growth.
“Today, the price of large-cap growth is a value,” said Robert Hagstrom, manager of Legg Mason's Growth Trust, at a recent Morningstar conference panel discussion entitled “Is Growth the New Value?”
His contention is echoed by the Leuthold Group's June Green Book, which says that following a period of horrific underperformance by growth stocks “large-cap growth remains significantly undervalued relative to large-cap value.”
Growth on the Cheap
Since February 2002, the large growth issues are off 40 percent while value equities are trading higher by 50 percent. That disparate performance has made growth much cheaper than usual. As Leuthold notes, the multiple on large-cap growth, at 23.5 times, is 5 percent below its historical average, while the multiple on large-cap value, at 11.9 times, is 19 percent above its historical average. Devoted followers of the “buy cheap” doctrine with a sense of history should be looking at large-cap growth.
Students of market performance will recognize that cheap things often stay cheap. Point being, if value has outlegged growth for five years, why switch now? On this point, Morningstar panel member David Corkins, who runs the Janus Mercury fund, is helpful.
“We tried to break down economic cycles and find when growth outperforms value,” he says. “The classic time is typically 30 months after the economy comes out of recession. If we look now, it's been 43 months since recession end and we are more than a year past the time growth stocks typically outperform.”
Corkins also argued that growth stock fundamentals offer a better deal: With growth you get 32 percent higher return on equity and 30 percent higher growth, while on the valuation side, free cash-flow yields are the same and price-to-earnings multiples are just 3 percent higher. “So you're getting much higher return businesses with much faster growth for almost the same price,” he notes. “I can't tell you when the stocks will change, but I can tell you there are more opportunities in growth stocks.”
Hagstrom also sees a rally approaching. “Large-cap growth is definitely due and definitely cheap, but my gut tells me its going to be hard to make a meaningful advance before the Fed has stopped raising rates and oil has stopped going up,” he says. “When those two things occur, it's off to the races.”
Growth Choices
Both Corkins and Hagstrom are revving their engines. Corkins has run Janus Mercury since February 2003, and his contribution (or alpha) has been positive, even though large-cap growth has been a stinker. For the 12-month period ending March, Mercury returned 3.8 percent, versus. 1.8 percent for the average large-cap growth fund. Since taking over, Corkins has concentrated the fund's holdings and allocated three-quarters of assets into classic growth names and one-quarter into “fallen growth.” The idea is to have some stocks working, even when growth stocks are not in favor.
Classic growth is typified by Roche Holdings, which owns 56 percent of fast-growing cancer therapeutics biotech firm Genentech, and more besides.
“Roche used to be known as Roche Bank, and they've been divesting not just financial but also manufacturing assets, and in fact just sold a manufacturing facility to Bayer,” says Corkins. “With Roche, you've got all the Genentech upside, you've got international marketing opportunities and you've got a restructuring story as well. So there's lots of ways to win.”
An example of a special situation for Corkins would be Liberty Media, John Malone's diversified holding company. “Last year they spun off the international cable business, which has done fantastically well, and they're talking about spinning off the Discovery Channel, which they own,” says Corkins. You may think of it as a value company, but “I think they've agreed to recognize those values, rather than hold them forever.”
Hagstrom's fund is another premium performer. Since the Growth Trust's inception, Hagstrom has produced market-beating average annual returns of 11 percent, while averaging a 2 percent return over the past five years. That may not sound impressive, but if you keep in mind the average large-cap growth fund lost an annualized 15 percent over the span, you acquire greater appreciation for Hagstrom's skills. Given Hagstrom's degree in Buffettology (he wrote a book on Warren Buffett), it's of interest that he no longer holds any Berkshire Hathaway shares. Corkins does, and the difference between the two managers illustrates how they approach growth stock valuation.
Two Takes
Corkins likes the huge float (or cash generation) of Berkshire's insurance assets, which when invested will drive profit growth. “Remember, [Buffett's] got $45 billion to deploy,” says Corkins. “Recently he bought the utility PacificCorp. We think that even at a regulated rate of return, Berkshire's return on capital will accelerate. The stock's a little beaten down because of the AIG investigation, but we're pretty comfortable that risk is in the price.”
Berkshire trades at 1.3 times book value; AIG trades at 1.7 times. This means that “Berkshire is an inexpensive stock with accelerating returns that's under a temporary cloud,” Corkins says. “The insurance float is free so anything Buffett earns on that offers incredibly high return on capital. Where else can you find that in the market for 1.3 times book?”
Hagstrom takes a different view. Though the manager concedes the likelihood that Berkshire will grow faster than the S&P, he finds that true as well of Pfizer and Citigroup, companies he sees growing around 12 percent or 13 percent compared to the market's 7 percent to 9 percent.
“I don't have a problem buying slower-growing growth companies, but when I buy them I want to get an extra-large discount to what they're worth so I get an extra return from the closing of the gap.”
Since Berkshire “isn't trading like a 50 cent-on-the-dollar investment” he'll stick with shares of a company like Amazon, a 25 percent grower in his view. With an eBay or an Amazon, “you don't need as much of a discount because the value creation that's going on each year is pretty dramatic,” he says. (Corkins agrees that Berkshire is not about to grow at an Amazon-like rate, explaining, “It's not priced to do that.”)
Asked his favorite investment for the next three years, Hagstrom doesn't hesitate to cite Amazon, which now comprises 7 percent of Growth Trust. To Hagstrom, Amazon is misperceived as a net retailer and is in fact a distributor of retail products, far more like Dell than Wal-Mart.
Amazon turns its inventory at 17 times, compared to Wal-Mart's 8 times, and, given its miniscule capital requirements, generates return on invested capital of 44 percent, twice that of Wal-Mart.
Says Hagstrom, “Wall Street thinks Amazon is expensive when compared to Wal-Mart, but if they compared it to Dell, they might see it as deeply undervalued.”
The bottom line in all this is that up-is-down investors could do far worse than consider entering the out-of-favor arena of growth stock investing.
