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

Look for companies that grow earnings faster than the overall market

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As we scan today’s investment horizon, it’s hard to miss what appears to be an attractive opportunity to invest in some of the world’s largest, most profitable companies at bargain prices. We’re 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 it’s 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

It’s 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 company’s 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 today’s market, however, that is no longer the case.

Opportunities in Today’s Market

Despite the market’s 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.

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