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Are Growth and Value Dead? Lawrence S. Speidell, Partner Nicholas Applegate Someone once said: “Nowhere is value so perfectly calibrated with price as in cigars”. Unfortunately, stocks are not cigars; and as a result, investors have searched for years to identify the perfect clue to value, and thus to future performance. The search for value in stocks has led to elaborate frameworks for the valuation of investments as well as elaborate frameworks for the evaluation of the styles of investment managers themselves. In light of recent market volatility, these frameworks may deserve some reexamination. 1999 was the sixth consecutive year in which the S&P BARRA Growth Index outperformed the Value Index. Some investors have questioned whether Value will ever again be a successful investment approach. Some of them believe this is a “New Era” in which technology stocks are revolutionizing the way business is done: “New Economy” stocks will survive while “Old Economy” stocks (mostly Value stocks) will become extinct. Other investors say that growth stocks are mostly driven by a technology stock bubble which is bursting and will lead to a return of classic fundamental analysis, favoring value stocks. Then there are observers who believe that the debate is defined too narrowly. They say that “Traditional” or “Deep” Value is too rigid a definition, whereas the concept of “Flexible” Value will better cope with the opportunities changing the world. Finally, there are observers who question the whole Value/Growth framework, which has been used widely since Callan is believed to have established it in the mid-1970s. Some of these critics say that Growth is not the opposite of Value; it is the creator of Value – without understanding potential for growth, one cannot correctly identify value…. History Value investing (in fact all professional investing) traces its roots to Graham and Dodd’s classic book Security Analysis, first published in 1934. At the depths of the Depression, they stressed the importance of fundamental analysis and the use of financial statement data to compare stocks. Over the last 30 years, practitioners have applied the term “Graham and Dodd” research to describe value investing as opposed to growth investing, but the authors did not make that distinction. Their discussion of sound investment value included assessing the “favorable possibilities for future growth”. With the rise of institutional investing in the 1960’s and 1970’s, however, the practice of dividing security analysis was divided into two basic camps, value and growth investing. Consultants, especially at Callan Associates, adopted these styles as two opposite poles and built them into today’s framework of portfolio diversification. Academic researchers have explored the characteristics of the value and growth styles, and they have often concluded that value stocks can be defined as stocks with a low price/book ratio, while growth stocks tend to have a high ratio. They have further suggested that value stocks (so defined) tend to outperform the socalled growth or “glamour” stocks. Numerous papers discuss this topic, including Fama and French [1993]. Dave Umstead and Lyle Davis [1995], Josef Lakonishok [1994], Barton Biggs [1995] and Bill Sharp [1993]. Ibbotson Associates published a chapter in their Yearbook 2000, which concluded that from 1927 to 1999, value stocks had returned 13.4% per year whereas growth stocks had returned only 10.2%. By the mid-1990’s many academic papers stated flatly that “Value outperforms Growth”, and some institutional investors responded by terminating their growth managers or at least tilting their asset allocation in favor of value. Unfortunately, many of these moves came at precisely the wrong time, as shown in the chart below. Figure 1 S&P/Barra Value Index vs. Growth Index 20.00 10.00 5.00 -10.00 -15.00 -20.00 -25.00 As shown in Figure 1, from 1975 to 1993, Value outperformed in 11 out of 19 years. From 1993 on, however, value has not outperformed at all. At the end of 1999, the firm of AXA Rosenberg found that their measure of growth stocks outperformed value stocks by 125% over the prior 18 months, representing a 6.8 standard deviation event, which “should occur only once every 285 billion years”. Benchmarks Part of the issue of Growth versus Value lies in the validity of the benchmarks we are using to describe these disciplines. Most index providers use similar methodologies, but there are differences as shown in Table 1 below. While BARRA, Russell, Wilshire and MSCI rely heavily on Price/Book as a discriminator, Russell also uses Estimated Growth, Wilshire and Prudential use Earnings to Price and Salomon used three growth and four value measures. Table 1 Value/Growth Index Methodology: Book to Price Est 5 yr Growth Earnings to Price (IBES) (on IBES 1 yr est) S&P/BARRA Yes No No Half market cap in each index Reconstituted 1/1 & 7/1 Russell U.S. Yes Yes No 70% of stocks are Growth or Value 1999 1997 1995 1993 1991 1989 1987 1985 1983 1981 1979 -5.00 1977 0.00 1975 Value Return % less Growth Return % 15.00 Russell non-U.S. country 30% of stocks partly in both Reconstituted 6/30 PB, P/Cash Flow, PE, IBES 5yr est growth equal weighted scores within Stocks are either growth or value MSCI Yes No No Wilshire Yes No Yes Salomon Prudential Score = 75% B/P + 25% E/P Half market cap in each index Reconstituted in June Growth Stocks have high: 5 yr EPS, Sales Growth Retained ROE Value Stocks have high: B/P, Cash Flow/P, Sales/P, Yield Roughly 25% of names and 50% of Cap is all Growth or Value, remainder are probability weighted in both indexes Growth Stocks have: Value Stocks have: Sales growth > 10% IBES Est 5 yr Growth > Median Low Dividend Payout Low Debt/Capital Earnings/Price > Median Dividends constant or rising Thus, the benchmarks are different, but most of them rely heavily on Book to Price. While simple, this approach may not be relevant. All the style indexes, however, ignore the real complexity of money management. Value investors do more than seek simple cheapness as measured by BP or EP, and growth investors don’t just look for expensive stocks. Oversimplification of the definitions of Growth and Value can cause unreasonable distortions of the asset allocations of institutional investors. Fundamentals A study by Chicago Investment Analytics, Spring 2000, looked at the underperformance of Value stocks and measured fundamental differences between Value and Growth (based on Earnings/Price) in the top 1000 stocks going back to the mid-1980s. They found, for example, that value stocks have generally had estimated future growth rates of 10%, whereas for growth stocks the estimated growth rate has recently accelerated from 20% to 29%. Similar relative improvements on the part of growth stocks were also found in Sales Growth (see Table 1), Earnings Surprises and Estimate Revisions. Table 1 5 Year Estimated EPS Growth Annual Sales Growth Positive Earnings Surprises % upward EPS Revisions Value Historically 10% 6-7% 53% 45% Value Now Same Same Same 42% Growth Historically 20% 15% 54% 43% Growth Now 29% 29% 70% 58% While the market may have overreacted, nevertheless, there have been fundamental improvements behind the recent out-performance of Growth versus Value. What do we mean by “value”? One problem is with Value investing is this word “Value”. When we use the term value in our daily lives, we generally mean it as a measure of quality relative to price, (or quality per dollar: Value = Quality / $). Price itself determines whether a coat or a car is cheap or expensive, but price does not determine whether it is a good value. One can trade off price and quality in the same way we do Risk and Return in the Efficient Frontier of investing. Thus, we can think in terms of a Quality Frontier for every product we buy: If we pay a little more, we should get something that is better quality. In an ideal world, value would be perfectly calibrated to price, as in the opening quote about cigars. However, in most areas of the economy, the quality frontier is not a straight line, but rather an upward sloping curve which reflects diminishing returns in quality as the price goes higher. (A Cadillac is a little better than a Chevrolet, but a Chevrolet is a lot better than walking). While the slope of a quality curve flattens at higher prices, the behavior of our preferences is just the opposite. For each person, we can construct Utility Functions which are curves of equal value. We make a purchase when our Utility Function touches the Quality Frontier. The shape of our Utility Function will change on days when we feel richer or poorer, but often we may find the value of two products (a Ford and a Mercedes) to be similar even though one is expensive and the other cheap. Thus the Value of a product is not its price or cheapness, but rather its Quality compared to its Price (V = Q/P). Figure 3 V alue Fram ew ork U tility Functions Quality Q uality Frontier B uy P oint P rice In the world of investing, however, Value is commonly represented as the amount of Earnings, Dividends or Book Value per dollar of Price. When some investors talk about “value” stocks, they are simply talking about cheap stocks. They are saying nothing about the quality of those stocks. In fact, Growth is not the opposite of Value, any more than growth investors set out to buy stocks that are bad values. Today, most institutional investors behave in very similar ways: They all get the same news feeds, databases and street research, and they all cover most aspects of classical Graham & Dodd research. Real information advantages are scarce (particularly given the SEC’s rules on non-public information). Thus, differences among investment firms are more in where they focus the emphasis of their work rather than what they leave out completely. They all build portfolios based on the same basic steps: Acquisition of information, the estimation of future streams of earnings, dividends and cash flows, the estimation of asset values and the estimation of risk. These results are then compared with a stock price to reach a buy, sell or hold decision. A “laundry” list of analytical tools and activities is shown in Table 2, below. Value mangers are likely to focus more on those at the top of the list; while growth managers spend more time on those at the bottom. Table 2 Accounting Measures Earnings Dividends Cash Flow Book Value Asset and Liability Valuation Accounting analysis Valuation Models Discount Models: Discount rates, fade rates, sustainable growth rates Fade Rates Enterprise Value Added, cost of capital Cash Flow Return on Investment, replacement cost, present value of Plant & Equipment Price Targets GARP, PE versus Growth Rate Subjective Fundamental Measures Management Quality Alliances Research & Development New Products Strategy Growth Measures Earnings Growth Sales Growth Cash Flow Growth Retained Return on Equity Change Measures Estimate Revisions Earnings Surprises Fundamental Catalysts Price Momentum Evolution of the Economy The stock market and the economy have changed greatly since Graham and Dodd wrote Security Analysis in 1934. At that time, many stocks were depressed below their liquidation value. Some even had liquid assets in excess of their market capitalizations. By the 1960s most of these values had disappeared, but America still dominated many capital-intensive industries. And as a result, many stocks with low Price/Book did well. In the late 1970s, our competitive economic position had eroded, but many basic industry stocks benefited from the inflationary global boom in commodity prices. Then in the late 1980s many industrial stocks benefited from aggressive restructurings, which improved margins and unlocked values. Today, however, many easy gains from security analysis have been realized. The stock market is more efficient. Also, unfortunately, the global competitive outlook for companies in many traditional U.S. industries is not good. More than ten years ago, management consultant Peter Drucker predicted the rise of new Knowledge-based companies to replace the dominance of the old, mature Production and Manufacturing-based companies in our economy. This forecast has come true. There has been enormous vitality and innovation in Knowledge-based companies in technology, health care and financial services. This has produced strong job growth in the U.S., although many jobs in the Old Economy” sectors of manufacturing and production have disappeared. Today, the economic position of the U.S. is strong globally, not because we have protected our Old Economy companies, but because we have stimulated the New Economy companies. Unfortunately, this evolution in economic leadership has presented challenges to investors. One challenge is that historical cost accounting may be less reliable for comparing values today because it treats New Economy and Old Economy companies unevenly. In the Old Economy, hard assets iof manufacturing and production companies have had measurable useful lives for depreciation purposes, often specified by tax codes. Today, however, those lives can be shortened unpredictably by technological obsolescence. This can cause Old Economy companies to overstate their assets, book values and earnings. Meanwhile the assets of Knowledge-based companies in the New Economy have assets which may be understated, because they are hard to quantify from an accounting standpoint. Innovations, patents, goodwill, R&D, brand, employees and market share are all unrecognized or understated under GAAP accounting. Because of these distortions, accounting data has lost some of its power in identifying stock market values. Another challenge comes from the intense competitive dynamics of many New Economy industries. Michael Price (XXXXXrefrenceXXX) in the Gorilla Game described this as a “winner take all” environment. It is driven by the economics of products where development costs are high but production costs are low, as in computer software. In these types of businesses, the goal is to gain a monopoly by lowering prices to discourage competitors while gaining enough volume to offset the initial costs. Companies that can gain an edge in market share can then drive out the competition, as VHS videorecorders did with Betamax. Treasury Secretary Larry Summers describes this an “accelerator” economic model (where higher production volume lowers production costs, encouraging lower prices, which increase demand and lead to still higher production volume). This can be contrasted with the “thermostat” model of the Old Economy (where higher production volume meets capacity limitations, increasing costs and thus reducing customer demand). In a “winner take all” environment, the law of “regression to the mean” does not work. Companies which are losers will always look like great values, while their fundamentals continue to deteriorate. Jack Welsh at GE pioneered the strategy of leadership in every business., and in the competitive New Economy, this is a fundamental strategy. In the New Economy, response to change is crucial, and history is a poor guide to the future. Just because a stock or industry is selling at a new all-time low valuation on Book to Price does not mean that it will revert to its historic valuation. Evolution of Investment Styles In this changed environment, investors have responded with new approaches to valuation, often pioneered by new “maverick” firms. With success, some of these disciplines have been copied and incorporated into the mainstream. The result has been a multiplicity of investment styles that goes far beyond the original simple framework of Value versus Growth. It is time to think of a new landscape of investment styles, which can encompass new developments in valuation techniques and can recognize that “value” can be found in many ways and in many places in the market. What really separates investors is not a difference in their commitment to finding good values; it is differences in their willingness to look out into the future, to accept growth. If they are doubters, they will be skeptical about future growth. The time horizons of their analysis will be short, and they will focus more on current earnings and assets. They will spend less time assessing the impact or the likelihood of long term growth. As a result, their portfolios will have stocks with lower growth rates, where the payback for investing is more immediate. Other investors, however, are more willing to believe in forecasts. They look forward over long time horizons, and they have more confidence in their ability to identify the potential of a company’s products in the future. These investors will own companies with higher future growth rates. Therefore, in constructing a framework for discussing and comparing investment styles, we can use a scale based on the growth rates of stocks in managers’ portfolios, from low to high. This reflects the time horizon managers use in their analysis, but is easier to measure. For this scale of growth, we can use IBES Estimated 5 year growth, possibly combined with historical sales growth (already Russell uses IBES Estimated 5 year Growth as one of its measures, and Prudential uses both IBES Estimated 5 year Growth and historic sales growth). In addition to this horizontal growth scale, however, we suggest measuring managers on a vertical axis scale which would capture the trend of recent positive and negative changes in fundamentals. The resulting framework is presented in the Style Map below: Figure 4 This Style Map has several features: 1) On the horizontal “Growth Axis”, Low Growth/Short Horizon and High Growth/Long Horizon are the extremes, capturing the relative optimism or skepticism of investors about the future. Over time, the median of the population of investors will shift to the right or left depending on the stability of the outlook (in 1999, it shifted to the right with a vengeance; but five years ago, due to the Fama and French paper endorsing “value” stocks, median manager probably moved toward the left). 2) On the vertical “Trend Axis”, Positive Change and Negative Change identify investors who tend toward being either trend followers or contrarians. Generally, however, only retail investors and a few quantitative investors would be at the upper or lower extremes of Momentum or Contrarian Styles. At these extremes, analysis is primarily Technical rather than Fundamental. Thus, the Ellipse is drawn to define the limits of Fundamental Analysis, with pure Technical Analysis roaming beyond its frontier. 4) Analytical Tools are shown in Red: 1) Yield is the province of Deep Value investors. It drives portfolios into low growth stocks and often stocks which have become particularly cheap because of negative fundamental changes (the highest yields often come just before dividend cuts). 2) Book to Price and Earnings to Price are used most heavily by the index providers and academics. Lately, however, they have developed several accounting pitfalls mentioned above. Rapidly growing companies are often penalized by write-offs of advertising, R&D and goodwill; while slower growing capital intensive companies may not be writing off assets quickly enough, leading to understatement of their depreciation and overstatement of their book values. As the U.S. economy moves from a production base to a knowledge base, these distortions have widened the gap in accounting between traditional value and growth stocks. 3) EV/EBITDA (Enterprise Value / Earnings Before Interest, Taxes and Depreciation) has grown in popularity recently. Because it adds debt and equity together, enterprise value is less sensitive to negative relative price strength than B/P or E/P, but the addition of interest and depreciation to pretax earnings causes a bias in favor of capital-intensive companies. 4) Fundamental Catalysts have been sought for many years by value managers in order to avoid buying declining stocks too early. Now catalysts are widely discussed all investors as early buy signals. 5) DDM, CFROI and EVA are quantitative valuation models which have been widely adopted. While often conceptually accurate, they suffer in practice from estimation difficulties. Discount models, for example, are extremely sensitive to estimates of the duration of growth, the fade rate of growth, the terminal growth rate and the discount rate. 6) Earnings Surprises and Estimate Revisions are powerful indicators of positive change. The power of Estimate Revisions has been confirmed by studies in behavioral finance, which have found that analysts tend to “anchor” their estimates to their previous number and thus under-react to new information. This effect is likely to continue to be important. Earnings Surprises, however, may lose some of their power as they fall victim to the game between managements and analysts over quarterly estimates. While companies talk down their expectations so they can report a positive surprise, analysts have begun to withhold their best estimates from published databases so they can tell their favored clients their higher “whisper” number. Recently, the market has become more volatile as the SEC’s Fair Disclosure rule has prompted companies to reduce the flow of information. 5) Investment Styles are shown in Blue Italics: a. Deep Value, Absolute Value, Traditional Value and Yield-Based Value are the oldest value styles, which rely on relatively short forecasting horizons. They have been challenged in the recently volatile market.. b. Flexible Value and Relative Value are more moderate styles, which have performed somewhat better then Deep Value. They may seek bargains across industries and sectors or they may seek companies which are historically cheap. This approach may underestimate the importance of leadership in some industries. c. E) GARP (Growth at a Reasonable Price), is shown as a diagonal line moving down to the right. This style can buy stocks across a broad range of growth rates, but among higher growth rate stocks, it typically looks for cheapness. Unfortunately, some of these stocks are cheap for a reason….they are suffering negative change. d. F) Traditional Growth and Earnings Momentum Growth are on the right, differing in the degree of their interest in positive change. Investors have been successful at recognizing when old valuation tools are no longer useful and developing new tools to gain an edge over the “efficient” market. It is time to develop new tools as well for looking at investors and for understanding the differences in their styles. The traditional yardstick of Value versus Growth has always been flawed by the fact that growth is not the opposite of value, but rather an important element in it. Value and Growth are not dead, but the Style Map provides an opportunity to measure mangers more precisely, by the tools and the time horizons they use rather than by backward-looking accounting measures. Successful investors will lie in all quadrants of the Style Map. There is room in institutional investing for investors who seek strong or weak current trends and who seek high or low growth, using long or short horizons. REFERENCES Barton M. Biggs, “Value will out” Morgan Stanley Strategy and Economics, April 10, 1995 Carlo Capaul, Ian Rowley and William F. Sharpe, “International Value and Growth Stock Returns” Financial Analysts Journal, January-February 1993 W. Scott Bauman, C. Mitchell Conover and Robert E. Miller, “Growth versus Value and Large-Cap versus Small-Cap Stocks in International Markets”, Financial Analysts Journal, March/April 1998 Eugene F. Fama and Kenneth R. French, “Common Risk Factors in the Returns on Stocks and Bonds”, Journal of Financial Economics, 33, 1993 Benjamin Graham, David L. Dodd and Sidney Cottle, Security Analysis, New York: McGraw-Hill, Fourth Edition, 1962 Robert A. Haugen, “The Race Between Value and Growth”, The Journal of Investing, Spring 1997 J. Lakonishok, A. Shleifer, and R. Vishny, “Contrarian Investment, Extrapolation, and Risk.” Journal of Finance December 1994 Richard O. Michaud, “Is Value Multidimensional? Implications for Style Management and Global Stock Selection” Journal of Investing 1997 Ernesto Ramos & Lawrence Speidell, “Do Estimate Revisions Work in International Markets”, The Journal of Investing, Spring 1998 Dennis Trittin, “Value Tilts - Why the Free Lunch and the Active Manager Enigma?”, Russell Research Commentary, November 1994 David A. Umstead, “International Equity Style Management”, Equity Style Management, Chicago: Irwin Professional Publishing, 1995 Richard S. Yeh and Yazid M. Sharaiha, “Global Style Investing with MSCI Value and Growth Indices”, Global Equity and Derivative Markets, Morgan Stanley Dean Witter, December 1997 Robert D. Barkley, of Barrow, Hanley, Mewhinney & Strauss Inc., “Style allocation drift”, Pensions & Investments, April 17, 2000 Robert J. Pelosky and Hernando Cortina, Morgan Stanley, Global Strategy, MacroMorphosis, March 22, 2000 Peter Drucker, “Putting more now into knowledge”, Forbes Magazine, May 15, 2000 Lawrence S. Speidell Nicholas-Applegate Capital Management [email protected] Have we miss-specified the Style Map…. Are Value and Growth Dead? The Markets… Have Been Volatile Value Has Been Under Siege…. Growth Has Been Under Siege…. Value Is Now Back on Top…. Large Growth R1000G Small Growth R2000G Large Value R1000V Small Value R2000V Investment Styles: The Traditional Framework R1000V = 2838.7 R1000G = 3091.9 4 5 8 9 9 0 4 5 8 8 9 0 1 2 3 6 7 1 2 6 7 3 -7 c-7 c-8 c-8 c-8 c-8 c-8 c-8 c-8 c-8 c-8 c-8 c-9 c-9 c-9 c-9 c-9 c-9 c-9 c-9 c-9 c-9 c e e e e e e e e e e e e e e e e e e e e e e D D D D D D D D D D D D D D D D D D D D D D 100 1000 10000 Russell 1000 Growth vs Value Value and Growth are Close after 20 years Value Return % less Growth Return % --22 55 .0 .0 00 --22 00 .0 .0 00 --11 55 .0 .0 00 --11 00 .0 .0 00 --55 .0 .0 00 00 .0 .0 00 55 .0 .0 00 11 00 .0 .0 00 11 55 .0 .0 00 22 00 .0 .0 00 S & P /B a r r a V a lu e I n d e x v s . G r o w t h I n d e x 1983 1981 1979 1977 Source: Chicago Investment Analytics 1993 1975 1975-1993: 11/19 1994-1999: 0/6 1997 1995 But Value had a Losing Season: 1999 1991 1989 1987 1985 D 9 -7 c e -30 -20 -10 0 10 20 30 ce D 81 D 3 -8 c e D 5 -8 c e D 7 -8 c e D 9 -8 c e ce D 91 D 3 -9 c e D 5 -9 c e S&P/Barra Value Index vs. Growth Index D 7 -9 c e Will there be Mean Reversion? …or Mean Aversion? Value Return % lass Growth Return % (12 mos) D 9 -9 c e Growth Stocks have High: 5yr EPS, Sales, RROE Value Stocks have High: B/P, CF/P, Sales/P, Yield Growth Stocks: Sales growth > 10% IBES Est 5 yr Growth > Median Low Dividend Payout, Debt/Capital Value Stocks: Earnings/Price > Median Dividends constant or rising Prudential Yes No Salomon No No Yes Yes Yes Yes Est 5 yr Growth Earnings to Price (IBES) (on IBES 1 yr est) No No Yes No Wilshire MSCI S&P/BARRA Russell Book to Price What is Value? Source: Chicago Investment Analytics 5 Year Est EPS Growth Annual Sales Growth Positive Earnings Surprises % upward EPS Revisions Value Growth 80-95 Now 80-95 Now 10% Same 20% 29% 6-7% Same 15% 29% 53% Same 54% 70% 45% 42% 43% 58% Has Value Changed? 1Y Reported Sales Gth % -1 0 .0 0 -5 .0 0 0 .0 0 5 .0 0 1 0 .0 0 1 5 .0 0 2 0 .0 0 2 5 .0 0 3 0 .0 0 3 5 .0 0 H i g h E/P Source: Chicago Investment Analytics Figu re 12: 1Y S ale s Growth C om paris on Has Value Changed? 12/31/1982 09/30/1983 06/30/1984 03/31/1985 12/31/1985 09/30/1986 06/30/1987 03/31/1988 12/31/1988 09/30/1989 06/30/1990 03/31/1991 12/31/1991 09/30/1992 Lo w E/P 06/30/1993 03/31/1994 12/31/1994 09/30/1995 06/30/1996 03/31/1997 12/31/1997 09/30/1998 06/30/1999 10 100 100 200 300 1000 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 20 00 S&P 500 P r o f it s I n f la t io n A d ju s t e d N a t io n a l In c o m e a n d P r o d u c t A c c o u n t s C a p it a liz e d b y Q u a r t e r ly A v e r a g e 1 0 - Y e a r B o n d Y ie ld In d e x o f E c o n o m ic P r o f it s v s . S & P 5 0 0 What is Value? Price Follows Earnings Index, Q1 1991 = 100 -40 -30 -20 -10 0 10 20 30 -20 -10 Five Year Historical Earnings Growth 40 50 60 Japan 10 0 EAFE ex Japan United States 20 30 40 Decile Median Five Year Historical Earnings Growth and Five Year Annual Return 1997 What is Value? Price Change Follows Earnings Growth Five Year Annual Return 0 5 10 15 20 -50 0 25 50 Five Year Historical Earnings Growth -25 75 EAFE ex Japan Japan United States Decile Median Five Year Historical Earnings Growth and Long Term Growth Estimate 1997 What is NOT Value…. Growth Estimates Follow Historical Earnings Long Term Growth Estimate 0 1 2 3 4 -50 0 25 50 Japan EAFE ex Japan United States Five Year Historical Earnings Growth -25 1997 Decile Median Five Year Historical Earnings Growth and Price to Book Ratio 75 What is NOT Value… Price to Book Follows Historical Earnings Price to Book Ratio 0 1 2 3 4 5 6 0 20 30 EAFE ex Japan Japan United States Estimated Long Term Growth 10 1997 40 Decile Median Estimated Long Term Growth and Price to Book Ratio What is NOT Value or Growth… High Price to Book Sometimes Has High Est Growth Price to Book Ratio What is NOT Value or Growth… High Price to Book Sometimes Has High Est Growth 0% 25% 50% 75% 100% 5.2 US 3.0 Japan 2.1 EAFE ex Japan PB Ratio Technology & Health Services Commercial Services Consumer, Retail & Finance Transport, Energy & Utilities Manufacturing Top Decile of Companies by Long Term Growth Estimate, 1997 What is NOT Growth or Value… High Price to Book is Sometimes High Est Growth Percent in Sector -15 -10 -5 0 5 10 15 20 1 2 3 5 6 7 Price to Book Decile 4 8 Japan - 5 Year, 1 Year US - 5 Year, 1 Year EAFE ex Japan - 5 Year, 1 Year 9 Price to Book Decile versus One and Five Year Actual Earnings Growth 1985-1992 10 What is NOT Growth… Price to Book Does Not Predict Earnings Growth Actual Earnings Growth -25 0 -5 -10 -15 -20 25 20 15 10 5 1 2 4 5 6 7 8 Estimated Long Term Growth Decile 3 Japan - 5 Year, 1 Year US - 5 Year, 1 Year EAFE ex Japan - 5 Year, 1 Year 1985-1992 9 Estimated Long Term Growth Decile versus One and Five Year Actual Earnings Growth 10 What is NOT Growth… LTG Estimates Do Not Predict Earnings Growth Actual Earnings Growth Quality Price 2000 1970 Q uality Frontiers Value Fram ew ork What is Value? Quality U tility Functions Price B uy P oint Q uality Frontier Value Fram ew ork Value = Quality / Price Management Accounting Market Risk Specific Risk Transparency Visibility Growth What is Investment Quality? Matching Costs with Revenues R&D Advertising Goodwill New Economy Obsolescence Asset Values Depreciation Rates Old Economy Quality Issues in Accounting Winner Takes All Losers will always look like Great Values Returns revert to the extreme Game) Geoffrey Moore’s Theorum (Gorilla Quality Issues in Corporate Strategy Start-up Cost: $100,000 Unit Cost: $1,000 – falling, then rising New Economy – “Positive Feedback” Start-up Cost: $1 Mil Unit Cost: $1 - constant Old Economy – “Negative Feedback” Larry Summers: “Thermostat versus Avalanche” Quality Issues in Corporate Strategy Costs 1 10 100 1000 10000 100000 1000000 10000000 100000000 1000000000 0 25 50 75 Old Economy Cost/Unit = $1,000+ Units 100 125 150 175 Old Avg Cost/Unit Old Economy Total Costs Old Economy: Rising Volume = Rising Prices = Lower Demand Larry Summers: “Thermostat versus Avalanche” Quality Issues in Corporate Strategy Costs 1 10 100 1,000 10,000 100,000 1,000,000 10,000,000 100,000,000 1,000,000,000 0 25 50 75 New Cost/Unit = $1 Old Cost/Unit = $1,000+ New Total Costs Units 100 125 150 175 Old Avg Cost/Unit New Avg Cost/Unit Old Total Costs New Economy: Monopolies may be OK…. Larry Summers: “Thermostat versus Avalanche” Quality Issues in Corporate Strategy Source: Morgan Stanley Information overload Accelerated discounting Thin is in Real-time forecasting Future without history Collaboration/alliances Global standards One world sector selection 1999 - future Pre-1999 Information scarcity value Lengthy gestation More is better Long-term forecasting History leads the future Proprietary work Disparate disclosure Country/region allocation New Economy Old Economy Quality Issues in Corporate Strategy Source: Morgan Stanley Information overload Accelerated discounting Thin is in Real-time forecasting Future without history Collaboration/alliances Global standards One world sector selection 1999 - future Pre-1999 Information scarcity value Lengthy gestation More is better Long-term forecasting History leads the future Proprietary work Disparate disclosure Country/region allocation New Economy Old Economy Quality Issues in Corporate Strategy Regression to the Mean…Unreliable Historical Accounting… Less Valuable High and Low Growth… OK Response to Change… Crucial Quality Issues in Corporate Strategy Traditional Value Low Growth High Growth Traditional, Consistent Growth Landscape of Style: High Growth and Low Traditional Value Low Growth Short Horizon High Growth Long Horizon Traditional, Consistent Growth Landscape of Style: Growth & Time Technical Analysis Traditional Value Low Growth Short Horizon Technical Analysis Negative Change Contrarian Momentum Positive Change Technical Analysis High Growth Long Horizon Traditional, Consistent Growth Technical Analysis Landscape of Style: Growth & Change EV/EBITDA PE Based EP BP Yield Technical Analysis Deep Value Traditional Value Low Growth Short Horizon Technical Analysis Negative Change Contrarian Fundamental Catalysts DDM, CFROI, EVA, RROE Earnings Surprises Estimate Revisions Momentum Positive Change Technical Analysis High Growth Long Horizon Traditional, Consistent Growth Technical Analysis Landscape of Style: Tools of the Trade Yield Technical Analysis Deep Value Technical Analysis Relative Value Fundamental Catalysts DDM, CFROI, EVA, RROE Negative Change Contrarian GARP Technical Analysis High Growth Long Horizon Traditional, Consistent Growth Earnings Momentum Growth Earnings Surprises Estimate Revisions Momentum Flexible Value GARP PE Based EP BP EV/EBITDA Traditional Value Low Growth Short Horizon Technical Analysis Positive Change Landscape of Style: A Mosaic of Managers Landscape of Style: Recent Results Value & Growth are Not Dead…they are the same! High and Low Growth… OK Response to Change… Crucial Regression to the Mean…Unreliable Historical Accounting… Less Valuable Conclusions Yield Technical Analysis Deep Value Technical Analysis Relative Value Fundamental Catalysts DDM, CFROI, EVA, RROE Negative Change Contrarian GARP Technical Analysis High Growth Long Horizon Traditional, Consistent Growth Earnings Momentum Growth Earnings Surprises Estimate Revisions Momentum Flexible Value GARP PE Based EP BP EV/EBITDA Traditional Value Low Growth Short Horizon Technical Analysis Positive Change Landscape of Style: A Mosaic of Managers