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Value investing has benefits over growth investing

One of the constantly raging debates in the finance world is which investment approach is superior: growth or value?

Growth investors buy companies with above-average growth prospects, usually paying above-average price-to-earnings (P/E) multiples. Value investors look for companies selling at below-average P/Es, usually settling for companies with below-average growth prospects.

Proponents of growth stock investing often point to 10-baggers – stocks that have risen 10-fold or more in value during spectacular run-ups –when making the case for their philosophy. The mantra of value investors is that slow and steady wins the race. Who's right? Both sides have their statistics, but we all know that it's been said if you torture the numbers long enough, you can get them to confess to anything.

I obviously won't end the debate with this short column, but I will share why I am biased toward the value camp.

The biggest reason I favor value investing is that almost every spectacular growth-stock run-up is followed by a nearly equally spectacular implosion. The reason why is simple: no company can continue to grow its earnings faster than the overall economy forever, so the above-average P/E a company enjoys during its rapid growth phase inevitably has to return to average at some point. That adjustment from a high P/E to an average P/E – the technical term is reversion to the mean – can be very painful for your portfolio.

Making the game even trickier is the fact that markets tend to over-react–probably because markets are comprised of people who have a tendency to feel overly optimistic when things are going well and unjustly pessimistic when things are going poorly. So, when a rapidly expanding company's growth rate slows and its P/E compresses, often times the stock price is punished more than is justified.

There are countless real-life examples–take Home Depot, for instance. In 1999, it was trading at $69/share, a P/E of 60. Since then, the company 's earnings nearly tripled, but the stock is now trading below $40, or a P/E of about 13. Why? Because growth slowed from the heady 30 percent rate of the 1990s, and 20 percent from 2000-2006, to an expectation of flat to slightly lower earnings in 2007 due to the well-publicized slowdown in U.S. real estate sales.

In 1999, at a P/E of 60x, Home Depot shares were priced as though earnings would grow 25 percent annually forever. But, now, at a P/E of 13, the shares are priced as though earnings may never grow again.

Let's look at a hypothetical comparison of two companies with the same earnings per share of $3 but divergent growth prospects. One company, HARE, is trading at a P/E of 30 because investors are excited about its prospects for growing earnings at a 20 percent annual clip. The other company, TRTL, is trading at a P/E of only 13, like Home Depot is currently trading, because its 8 percent expected long-term growth rate is merely average. HARE pays no dividends because management prefers to reinvest in its rapidly growing businesses; TRTL shareholders receive a 2.4 percent annual dividend.

If both companies deliver on their current growth expectations, but both end the five-year period with average expectations for future growth (and their P/Es revert to the long-term average of 15), the return differential is huge. Holders of HARE only realize a return of 4.5 percent, while TRTL holders enjoy a 13.5 percent return.

Of course, if HARE's P/E remained high due to continued high-growth expectations, shareholders could enjoy much higher returns–you just have to try to sell before the growth slows and the P/E contracts. In reality, as you might expect, it 's not that easy because the contraction in P/E usually occurs before the company's EPS growth actually declines.

In order to be a successful investor buying growth stocks, you really have to, in the words of country music singer Kenny Rogers, Know when to fold 'em. If you don 't want to drive yourself crazy guessing whether the 25 percent pullback in your growth stock is just a normal correction  that growth stocks periodically suffer during their rapid growth phases or the beginning of the growth rate (and P/E multiple) crashing down to earth, stick to buying value stocks that are justified by current earnings and dividends. You 'll sleep better and enjoy superior returns over the long run.

– Scott Tapley, CFA, is a vice president/financial analyst with the Main Street Wealth Management Group. He can be reached at 217-351-6539 or scott.tapley@mainstreettrust.com.

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