In this week’s Barron’s Lawrence C. Strauss has an interesting article on the “growth versus value” debate. It is is a dumb concept invented by quantitative analysts and pension fund consultants that has little utility for real investors who actually understand the companies they own. A “growth stock” with an above average PE multiple can be a much better value than a slow-growing “value stock” with a low PE multiple, low price-to-book multiple, and high dividend yield. The keys are A) not to pay an excessive PE for growth and, B) make sure the company really will grow as fast as you expect. Item “B” is much harder than it looks. I recall writing thematic research reports where we asked each analyst for his or her best growth idea; looking at the names a few years later, many of them turned out to be duds. (If you don’t believe me, take a look at a 2-year chart of 3D Systems.)
The most useful insight to be found in Mr. Strauss’ column is a quotation from Oakmark’s Bill Nygren, who notes that today “investors are overpaying for high yields, which usually implies slower growth, rather than overpaying for high growth.” In other words, you are more likely to find good value among growth stocks that don’t offer particularly high dividend yields.
To test this hypothesis, I carried out a simplistic but nevertheless instructive analysis of the 30 stocks in Dow Jones Industrial Average. For each company I calculated:
- Expected EPS growth in 2015
- Dividend yield
- PE on 2015e EPS.
Despite weak overseas economies, a strong dollar, and difficult comparisons after five years of S&P 500 earnings growth, a true “growth stock” should be able to grow at least 5% in 2015, given that the U.S. economy will grow about 3%. Here’s what I discovered:
- Slow Growers: The 20 companies with less than 5% growth have a median yield of 2.9%; their median 2015 EPS growth is just 1.3%. This implies a “total return” (yield plus growth) of just 4.3%
- Fast Growers: The 10 companies with more than 5% growth have a median yield of just 1.4%, but their median growth is a lofty 9.3%. This implies total return of 10.7%–far better than the 20 slow-growers.
- So, how much of a PE premium do you have to pay for the fast growers offering more than twice as high a total return in 2015? Very little. The median PE’s of the slow growers is 16.9x; that of the fast growers is just modestly higher at 17.7x.
Yield-starved investors are overpaying for stocks with juicy yields of 2.5% or more, even though many of these businesses face serious fundamental challenges that are stunting growth. I do not by any means claim to be an expert on all these companies, but here are some of the companies that may fit this description, followed by their 2015e EPS growth and 2015e PE:
- AT&T 1.2% EPS growth / 13.6 PE
- Caterpillar -25.1% / 17.8x
- Coca-Cola -1.5% / 20.9x
- DuPont 2.5% / 18.5x
- IBM -3.1% / 10.0x
- Intel 2.6% / 14.5x
- J&J 4.0% / 16x
- McDonalds 4.8% / 18.9x
- Merck -2.9% / 17.3x
- Pfizer -7.5% / 16.6x
- P&G 3.2% / 20.6x
- Wal-Mart 4.2% / 16.5x
I don’t hate all these stocks; in fact I own four of them. Some names may have temporarily weak earnings growth this year because of the strong dollar, the energy collapse, product cycles or special factors that won’t last forever. That said, it is fair to say that some of them—such as KO, IBM, MCD, MRK, PFE, PG & WMT – have fundamental problems that are likely to restrain earnings growth over the next few years, if not l longer. (Most obviously, Coke and McDonald’s are simply on the wrong side of the better and better-for-you healthy eating trend and show no signs of adjusting successfully.) Yet the average PE of the 12 names is a rather high 16.8x (median 17.0x). They are not great investments, in my opinion.
Now let’s look at the growth companies in the DJIA that are expected to grow faster than 5% this year. Of the 10, the 7 that appear to have the best fundamentals are:
- 3M 9.2% EPS growth / 20.3X PE
- Disney 10.3% / 20.8x
- Home Depot 16.5% / 21.4x
- Microsoft 7.7% / 16.4x
- Nike 13.1% / 24.7x
- UnitedHealth 8.8% / 17.7x
- Visa 14.5% / 25.1x
Their average PE is 20.9x (median 20.8x); the average yield is 1.5% which is not great but not nothing either. Their dividends are likely to grow rapidly; earnings growth is strong and the average payout ratio is 30% versus 50% for the 12 slow growers discussed above. Interestingly, for these seven growth stocks the PE-to-total return ratios (i.e., PE divided by 2015 EPS growth plus dividend yield) are mostly in a remarkably tight range of 1.65 to 1.81; HD is the outlier at just 1.18.
To find good growth names to buy, you could do worse than to look at the top holdings of Bill Nygren’s Oakmark Funds, which is available on the website.
Copyright Thomas Doerflinger 2015. All Rights Reserved.
