Why the Biggest Gains are in Growth Stocks, Not Value Stocks

As we scan todays investment horizon, its hard to miss what appears to be an
attractive opportunity to invest in some of the worlds largest, most profitable
companies at bargain prices. Were talking about large-cap growth companies.
Small-cap growth stocks often lead during the early stages of an economic
recovery. However, leadership often shifts to large-cap growth stocks during the
latter stages of an economic cycle. While its difficult to determine what stage
the economy is in right now, we expect that the current slow-growth environment
may persist for some time. In this uncertain environment, large-cap growth
stocks look like good relative values. Many large-cap stocks, especially those
of multi-national companies, will benefit more from faster economic growth
outside of the U.S., particularly in emerging markets. Most small companies
don't have the global reach to benefit from this trend. Defining Growth and
Value Its easy to get confused about what constitutes a growth stock, or for
that matter, a growth fund, as the definition has evolved over the years. But in
general, we consider a growth stock one where a company is growing earnings
faster than the overall market. Many growth stocks do not pay dividends.
Instead, they often reinvest almost all of their profits back into the business.
However, as some growth companies have built up huge cash hoards, shareholders
have demanded they return some of that money in the form of dividends (think
Microsoft (NASDAQ: MSFT ) or Intel (NYSE:NASDAQ: INTC )). Value stocks, on the
other hand, are companies whose shares trade either below their inherent worth
or lower than the market average. Value investors are shopping for bargains, and
as a result they tend to place significant emphasis on the price (or valuation)
of a stock. Because growth investors focus on a companys potential, they place
less emphasis on the current price of the stock and are more willing to pay
above-average valuations for attractive growth opportunities. Whereas value
stocks can be referred to as cheap or discounted, growth stocks have tended to
trade at a valuation premium to the over-all market. In todays market, however,
that is no longer the case. Opportunities in Todays Market Despite the markets
recovery from the lows of March 2009, price-to-earnings (P/E) ratios (a measure
of the amount investors pay for each dollar of earnings) on large-cap growth
stocks are well below their long-term average, especially when compared to value
stocks. In fact, P/E ratios on growth stocks would have to expand by almost 20%
just to get back to their average valuations relative to value stocks. The chart
below, which is based on the growth and value subsets of the Russell 3000 Index,
provides some perspective on the relative values in the growth and value stock
universe. It shows the relative P/E ratio between the Russell 3000 Growth and
Russell 3000 Value indexes from the beginning of 1979 through July 2011, which
we calculated by dividing the P/E ratio of the growth index by that of the value
index. The red line is the historical average (1.51), while the blue line shows
how the relative P/E ratio has varied from month to month. When the value of the
blue line is above that of the red, the relative value of value stocks is higher
than that of growth stocks. When the blue line is below the red, as has been the
case since the end of 2007, growth stocks are priced more attractively than
value stocks. Source: Adviser Investments, Russell Investments. Note: Chart data
from 3/31/79 through 7/31/11.