July 2005 Market Commentary

“A Bigger Universe” pdf version

We have always considered ourselves value investment managers, a seemingly vanishing breed as the 1990’s drew to a close. With today's stock market stuck in neutral gear, this seems like an appropriate time to address the age old investment style issue of value versus growth stocks.

In the late 1990’s there was a pretty clear demarcation between growth and value stocks. Value stocks tended to be in older industries, tended to have lower price to earnings ratios, frequently paid dividends and were generally viewed as the “old economy.” Growth stocks usually didn’t pay dividends, many were technology stocks, and were viewed as the “new economy.” They were certainly the sexier part of the market. There was even a tax advantage to investing in growth since capital gains were taxed far less than those old-fashioned dividends. By the end of 1999, those of us who favored value stocks were thought of as some type of quaint anachronism from a bygone age.

This all started to change in April of 2000 when the new economy started to exhibit all of the cyclical habits of the old economy and "dot com" became an analogy for "dot bust". The NASDAQ went from about 5,000 to about 1,200 and the S & P 500 fell about 37% over three years. Value was king in 2000 and 2001 and still looked pretty good relative to growth after 2003 and 2004, two years that enjoyed reasonable returns for the overall stock market.

There are those who have argued that value has had it’s run, that over time value and growth will revert to the mean and perform about the same over time. If that is the case they say it’s time to eschew value or at least reduce exposure to those stocks and move to the growth sector. There are a few problems with this.

The first is that many growth stocks now look surprisingly like value stocks with lower price earnings multiples and a few even pay dividends. Are Microsoft, Cisco, and Intel with price earnings multiples of about 24, 22, and 20 respectively and dividend payments in the case of two of them growth or value stocks? What about Pfizer with a 22 multiple and a 2.8% dividend yield? In addition, those stodgy old dividends now look much more attractive at the same 15% Federal tax rate as capital gains. Finally, is an economy growing at 3% to 3.5% a fertile ground for spectacular growth in any sector?

In many ways the growth versus value argument may be passé as more and more former growth stocks have morphed into value stocks with lower multiples, dividends, and more old economy characteristics. In the late 90’s we wrote an article comparing the values of an old economy stock owned by many of our clients with one of the hottest growth stocks of that time. Naturally we argued the case for the value stock. This was a time when we were criticized by some for not owning the particular growth stock. Times have changed. Last year we bought the same growth stock in many accounts because it fit our valuation criteria. We are still value managers but now the times have given us a much larger universe.

What happened in the 1990’s was not a lasting reality. It was a temporary period of unreality, a bubble that burst in a rather spectacular way. Sort of makes you wonder about other bubbles.

July, 2005