As the world navigates to the post-COVID era, the money has moved from growth to value stocks.
To demonstrate, the S&P/ASX All Technology Index (ASX: XTX) has lost more than 12% off its 52-week high. Meanwhile, the S&P/ASX 200 Index (ASX: XJO) has hit new all-time highs in recent weeks, shooting up more than 10% since the start of 2021.
The wisdom seems to be that as the economy picks up after the pandemic malaise, inflation will head upwards. Higher inflation can lead to higher interest rates, which are anathema to growth shares relying on future earnings.
But Montgomery Investments chief investment officer Roger Montgomery rejects the traditional categorisations of ‘value’ and ‘growth’.
“The conventionally accepted method of classifying value and growth stocks is subjective, arbitrary and engineered for convenience,” he said in a company whitepaper.
How ‘value’ and ‘growth’ definitions are flawed
Value and growth classifications are often made on a company’s price-to-earnings (PE) ratio. Sometimes analysts use price-to-sales to better reflect fast-growing businesses that don’t have massive earnings yet.
Growth stocks tend to have high ratios and value shares have low ratios.
REA Group Limited (ASX: REA) is an example of this. The online real estate advertising company’s PE ratio is now more than 158 after the stock price went from under $10 eleven years ago to $166.70 after close of trade Tuesday.
Even though banking shares have rallied in the past 6 months, a value share like National Australia Bank Ltd (ASX: NAB) is still selling at a PE ratio of just 20.5 at the time of writing.
And the growth story of 2020, electric car maker Tesla Inc (NASDAQ: TSLA) currently trades at a PE ratio of more than 608.
According to Montgomery, this is problematic.
“Classifying growth and value stocks purely on PE ratio or some other market multiple is flawed,” he said.
“Stocks with high PE ratios can be value stocks and stocks with low PE ratios may have them for a very good reason.”
Shares with massive PE ratios can also be ‘cheap’
Forager Funds chief investment officer Steve Johnson last month shared Montgomery’s discomfort about these traditional definitions.
The trouble is price-multiple calculations tell investors nothing about the upcoming potential of a business.
“‘Rocket to the Moon’ trades at 40x earnings, therefore it is expensive: It’s a lazy conclusion,” Johnson posted on Livewire.
“And it can be very wrong.”
Johnson said a business that keeps growing for many years can make current PE ratio judgments look absurd.
It’s yet another investment lesson on the impact of compounding.
“When a company compounds earnings exponentially, the fair value can be a seemingly absurdly high multiple of early-year earnings,” he said.
Cochlear Limited (ASX: COH) is one example Johnson cited, admitting that he dismissed it years ago based on its high PE ratio.
Two decades ago the stock was going for around $35 to $40, meaning a PE ratio of more than 30. According to Johnson, Cochlear has grown 15% per annum since then.
The stock closed Tuesday at $232.75.
“With the benefit of hindsight, you could have paid 150 times earnings and have still generated a 10% annual return (including dividends).”