Growth investors were surprised and dismayed a few weeks ago when U.S. Federal Reserve chair Janet Yellen pointed out in an interview that biotech and social media stock values were “stretched.”
They were not dismayed because it is quite unusual for the chairman of the Fed to mingle in the stock market. They were dismayed because they believe that these stocks’ superior forward growth rates justify current valuations and that they can still make money in these stocks despite their sky-high price-earnings multiples. And they have good company, as most analysts covering these stocks also agree with them judging from the overwhelming “buy” recommendations.
As a value investor, I read these comments and look at these valuations and my skin crawls. One of the biggest risks an investor faces is valuation risk – paying too much. You can buy the best company, but if you overpay you will not make any money. How do value investors guard against overpaying? The first step of the value investing process, which I will discuss today, is to search for low P/E companies, among other metrics.
Why is this so? The P/E multiple is a function of the growth rate of earnings going forward. This relationship can be found in a mathematical formula derived from the equity valuation model taught at every university. Companies have low multiples because markets expect low earnings growth. Companies have high multiples because markets expect high earnings growth. However, the way the growth rate comes into the mathematical formula implies growth forever. That is, a high-multiple company is forecast to sustain a high growth rate and a low-multiple firm a low growth, in both cases forever.
The markets tend to be over-optimistic about growth for high-multiple firms and overpessimistic about low-multiple firms. As a result, investors bid up (overvalue) high multiple firms and bid down low multiple firms. That is why value investors tend to avoid high-multiple firms. It is very difficult to make money when you buy overvalued firms.
My own published research has shown that, historically on average, low P/E stocks have beaten high P/E stocks by about 12 per cent in Canada, and in the United States, depending on the market, by between 7 per cent and 11 per cent. Research by Louis K.C. Chan and Josef Lakonishok, published in 2004 in the Financial Analysts Journal, shows that low P/E beat high P/E stocks by about 13 per cent in EAFE (Europe, Australasia and Far East) markets. They beat them in good times and bad times and when news is good and when news is bad.
How come? If one is overoptimistic about a stock most of the time, they tend to be disappointed in a down market and not so surprised in an up market, and when they are over-pessimistic about a stock they tend to be pleasantly surprised in an up market and not so surprised in a down market.
But if it is difficult to see the relationship between P/E and earnings growth, let me show you results of another study that actually looked at growth rates directly.
U.S. research by Michael J. Cooper, Gulen Huseyin and Michael J. Schill, published by the Darden School of Business, looked at the stock performance of high growth firms and compared it with the performance of low growth firms over a period of 40 years.
What they found was that low growth firms had an average return of 26 per cent, while high growth firms returned a meagre 4 per cent. The low growth firms outperformed the high growth firms by a whopping 22 per cent, annually on average, over a 40 year period.
Glamorous (high growth) firm stocks tend to attract a lot of attention, a lot of analysts following and a lot of trading by investors. By the time an ordinary investor decides to buy them, their prices have already been bid sky-high. In these cases it is difficult to make any money. The opposite happens with low P/E or low growth firms.
One can extend this analysis to countries, as well. High growth countries’ stock markets tend to become way too overpriced as they attract investors and funds and, as a result, they tend to have low forward returns. The opposite is the case for low growth countries. A case in point is the stock market performance of U.S. vs. the BRIC countries. Over the last five years, the best performing market in the world has been that of the United States and some of the worst markets in the world have been those of the BRIC countries.
So if you want to invest in high multiple or high growth firms, you must first look at the evidence and understand the history, unless you believe that this time it’s different. In this regard, I would like to quote Sir John Templeton, who said the most dangerous words in investing are "this time it’s different."
George Athanassakos, firstname.lastname@example.org, is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario. He is also the director of the Ben Graham Centre for Value Investing.