By Javier R. Jimenez
December 2000 - Investors traditionally have sought undervalued blue-chip companies for long-term investing. This practice is known as value investing, whereby you evaluate stocks according to book value, cash flows, price to earnings, price to sales, long-term debt, current assets vs. liabilities, and industry performance.
In recent years, however, as technology has enabled businesses to become more efficient and productive, there has been a shift toward fast-growth stocks such as Intel (INTC), Walmart (WMT), and America Online (AOL). Growth stocks are given a higher price valuation for their growth potential, while so-called old-economy stocks trade at lower price-to-earnings ratios. Furthermore, money flows, market conditions, and sector performance have a broader effect on growth stock prices. A good growth stock's revenue growth rate can be upwards of 15 percent, while a good old-economy revenue rate can vary from 5 percent to 15 percent, depending on factors such as industry, efficiency of business, and future outlook of the company.
This raises a question: Is old-economy stock still a good investment? Warren Buffett, for one, thinks so. Mr. Buffett, who made a name for himself with value investing – he's been able to average yearly returns of 26.7 percent for the last 30 years – has said investors should "behave according to what is rational rather than according to what is fashionable." Lately, old-economy stock has not been fashionable, partly because of the popularity of growth stocks and their recent colossal returns. But what's popular today is not always popular tomorrow.
Old-economy stocks such as International Paper (IP), Goodyear (GT), and Dow Chemical (DOW) are attractive because of their large cash-flow positions and book values and because they are less volatile than growth stock, especially during market corrections and economic downturns. The shift to growth stocks has created some excellent buying opportunities among certain old-economy stocks.
Moreover, money managers disagree on how best to evaluate growth stocks. Some compare sales growth, earnings growth, gross margins, strategic positioning within an industry, and breakthrough technologies. Consequently, identifying the next super growth stock is not an easy task. The variables are constantly changing, and competition has increased significantly. And as we've seen with recent corrections in the technology sector, the risks can be daunting.
So which investing strategy works best? As you've probably guessed, both are effective when used properly. Generally, old-economy stocks are easier to evaluate than growth stocks. They become attractive when price-to-earnings ratios are at lower levels and the outlook of the company looks substantially positive. These companies usually have proven management and a strong cash flow and balance sheet to expand or survive a downturn in the economy.
Good growth stock opportunities, as we've said, are much more difficult to identify. Solid evaluation of the company is very important. Characteristics to look for include breakthrough technologies, revenue growth, good gross margins, strong cash position, niche markets, and strategic partnerships – in other words, what you would look for in an old-economy stock minus the price-to-earnings ratio.
When is the best time to invest? The contrarian's answer would be that when either value or growth is out of favor, that likely is the best time to invest for the long term. Investors in the stock market have a tendency to overreact to news on a company largely because of two factors – greed and fear. The greed impulse wants us to make as much money as possible in the shortest amount of time, temping investors to invest in the hottest-performing stock until it's milked for every last drop of appreciation. The fear impulse spurs us into selling a good company at the worst possible time.
The famous Mr. Buffett once said, "I will tell you the secret of getting rich on Wall Street: You try to be greedy when others are fearful, and try to be very fearful when others are greedy." This contrarian approach to investing has enabled Mr. Buffett to become extremely wealthy, so it's probably sound advice.
Javier R. Jimenez is an investment executive with Wedbush Morgan Securities. This article is provided for informational purposes only. Its content is based on sources considered to be reliable, but its accuracy is not guaranteed. The information presented is neither an offer nor solicitation of an offer to sell or buy any security that may be mentioned herein. The information and expressions of opinion contained herein are not a representation by Wedbush Morgan Securities and are subject to change without further notice.
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