Price is what you pay. Value is what you get.
-Warren Buffett
The preceding quote is one of my favorite quotes from Warren Buffett. These two simple sentences - and the clear implication that the price and value of an asset are not always the same - stand at the core of what value investing is all about. This line of argument also stands sharply at odds with the conventional wisdom that you "You get what you pay for", the concept that underlies the efficient market hypothesis, which essentially states that the price of an asset is always an accurate reflection of that asset's intrinsic value, given the available information.
But do you really get what you pay for?
If anyone in the reading audience bought shares in a company like Etoys, which I mentioned in the first part of this column, then your experience has showed you that price and value are not always the same thing - sometimes price can be based purely on speculative excess, and have no connection to the value of a tiny, unproven business like Etoys.
The first part of this column highlighted a few of the pitfalls of invesitng in growth stocks - specifically the traps presented by unprofitable "growth stories" and companies with high growth expectations baked into their stock prices. In this column, I will discuss why sometimes even great growth stocks are simply too expensive to consider purchasing, and the tendency of growth stocks to suffer more than other stocks during broad stock market downturns.
David Dreman Looks at Growth Stocks as a Group
David Dreman, Chairman and Chief Investment Officer at Dreman Value Management, wrote an excellent book, Contrarian Investment Strategies: The Next Generation, in which he shares the results of his analysis of the Standard and Poor's Compustat database, a comprehensive database that contains decades of informaiton about stocks traded on exchanges in the United States. As part of his research, Dreman divided up the companies listed in the database by fifths (or quintiles) according to their PE, or Price to Earnings ratios, with the aim of seeing how stocks in various PE quintiles - raning from the cheapest quintile at the bottom, to the most expensive quintile at the top - performed over different time periods and under different conditions. The most expensive quintile contains shares that are "priced to perfection" - meaning that the expectation of smooth, rapid growth is already reflected in th estock price.
Dreman draws a wide variety of conclusions from this work, but the overall conclusion is that (as a group) the stocks in the cheapest qunitiles tend to outperform the stocks in the most expensive quintiles over most time periods greater than 1 year - and also outperform the broad stock market. For example, in the 27 year period between 1970 and 1996, the growth stocks in the highest PE quintile turned $10,000 into $137,000, only 47% of the return offered by the broad market, which was $289,000. Better yet, the value stocks in the lowest PE quintile turned that same $10,000 into $708,000!*
These results support Buffet's statement, demonstrating that value is what you get, and you are likely to get more of it when you buy a shares of a business at a low price. The case for price-concious investing is reinforced by the data that Dreman presents on another issue that is dear to the hearts of many investors: how to survive a bear market.
When the Bear Growls
One of the more interesting conclusions that Dreman draws in his book regards the performance of growth stocks vs. value stocks during a bear market. For the sake of simplicity, Dreman looked at each quarter in the 27-year period of the study, and deemed any quarter where the Compustat market average of 1500 companies dropped a "bear market quarter". During these quarters, the stocks in the cheapest PE quintile dropped 5.7%, less than the overall market, which dropped 7.5%. As usual, the results from the stocks in the most expensive quintile were the worst - an average drop of 9.5%!
So, what does it all mean?
Dreman's studies make a compelling case for being concious of value when buying stocks. Ultimately, we must trust our own judgement and research more than we trust the the market when it comes to determining the appropriate price for a stock.
None of the information presented in this column is intended to suggest that it is impossible to find a winning investment among the growth stocks that have the highest PE ratios, or that appear to be expensive by other measures. However, there is convincing evidence that it is very difficult to find outstanding investment returns by buying growth stocks, and that you will do better if you find stocks with great fundamentals and stromg prospects for growth before those prospects are already reflected in the PE ratios. The screen that I provided in part one of this column will help you to find such investments, and hopefully this two part column has provided some very good reasons to look for investments using this screeen.
* Contrarian Investment Strategies: The Next Generation, pgs. 155-157.
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