Growth stocks are popular because, you guessed it; they grow and become more valuable. Investors ignore their high price to earnings ratios (P/E ratio) and just keep buying. But how about using earnings and other factors as a guide? The question is, should you use earnings or growth as a guide when picking investments?
Should You Use Earnings or Growth as a Guide When Picking Investments: Overpriced growth stocks
The Toronto Globe and Mail has an interesting article about this subject. They point out a long term problem with growth stocks.
There is plenty and unequivocal evidence from academic research in Canada and around the world that, on average, value stocks (defined as stocks with low price-to-earnings or price-to-book ratios) beat growth stocks (those with a high P/E or P/B). For example, in recent research I carried out using U.S. data, I found that, on average, value stocks beat growth stocks by about 6 per cent over the 1982-2013 period.
The problem with popular growth stocks is that they become too popular and their prices get bid up beyond what fundamentals would support. We repeatedly suggest the use of intrinsic stock value as a guide to investing. In our article we pointed out that understanding how a company earns money and will continue to do so is basic to using intrinsic value as a guide to investing.
The ability to see into the future to see how well a company will manage its assets, products, costs, R&D, and marketing is of utmost importance in calculating intrinsic stock value as a means of deciding whether or not to purchase a stock.
The often repeated quote from Warren Buffett is useful in this case. He has tended to avoid tech stocks and focus on consumer stocks with strong brand names. This is because he does not know what a given tech stock will be worth or if it will even have a market in five years. But he has a pretty good idea that a product like Coca Cola or Snickers will be selling for five and ten years hence.
Should You Use Earnings or Growth as a Guide When Picking Investments: Underpriced value stocks
When investors look at the market they see certain stocks going up in price and other stocks languishing on the sidelines. There is a natural tendency to buy the stocks that are going up in price and ignore those that are on a flat price line. The fact of the matter is that when lots of investors pick growth over value they distort the market. Smart long term investors use this fact to pick up bargains for the long term.
Should You Use Earnings or Growth as a Guide When Picking Investments: Short Term Investing
The place for the majority of growth stocks is with short term investment. Good examples would be Microsoft from its IPO until just before the dot com bubble burst or at the depths of the Great Recession until now.