Economic Commentary
Category: Economic Commentary

Growth vs. Value and Supply vs. Demand

Sullivan's Market $ense: A column to help investors gain perspective on today’s market noise

Stocks can be divided into two types: Growth stocks and Value stocks. The differences can be subtle, and a single stock can be seen as both — or can move from one group to the other. Many investors and many investment vehicles refer to themselves as either growth or value. It is important to understand how these two types of stocks will behave in different environments. Growth stocks are those with above-average growth prospects. These companies are typically growing sales rapidly and may be growing profits rapidly. Sometimes they are growing sales so fast that they are spending all or most of their revenues on further growth. This may mean they have little or no profit. The Silicon Valley stocks often fit this picture. A more established growth company will have good sales growth and good profit growth. Investors buy these stocks because they expect the company’s profits to grow over time, and to grow faster than the average stock. A dollar of earnings today is worth more in stock price if it is expected to become two dollars of profits in the near future. Today’s dollar of earnings is particularly valued if the growth in earnings is expected to last a long time. Some of the beverage companies come to mind in thinking of long sustained growth of sales and earnings. A company that can grow earnings regularly, and even through a recession, is very highly valued when other companies are not growing earnings. Growth company stocks tend to fare better when growth is generally hard to find. As economic growth tops out in an economic cycle, growth stocks generally perform very well. As a recession begins to take hold they also do well because there are fewer and fewer companies able to maintain earnings growth. The other half of the market is made up of Value stocks. The companies underlying value stocks usually cannot maintain a steady growth in earnings. Either their business is cyclical, or it is subject to outside forces that cause interruptions in earnings growth. Value stocks generally sell cheaper than growth stocks because their earnings are less stable and they might not be able to grow earnings, or only at a very slow pace. Like anything referred to as value, these stocks are cheaper and have obvious drawbacks. The stocks of auto, industrial and energy companies are regularly classified as value stocks. Investors are interested in these stocks simply because they are inexpensive. They have bigger dividends, lower price-to-earnings ratios and lower price-to-sales ratios. When a recession is ending these companies recover, and move from losing money, to making very little, to making big profits. At this point in the cycle they outgrow the growth companies. At this point growth is not rare, it is abundant, and the value stocks regularly have the fastest growth. Earnings and earnings growth is what drives stock valuations. When earnings and earnings growth are plentiful, a company that can grow when others can’t is not highly valued. When earnings growth is rare, those companies that are still growing earnings are highly valued. When the supply of growth is high the value is low. When the supply of growth is low the value is high. After six years of tepid economic growth and six years of blistering earnings growth, companies are finding it harder to grow earnings. For the most recent twelve months the growth rate of S&P 500 earnings is about zero. It may accelerate during 2015, but isn’t going to reach the pace of a year ago’ s 8 to 10 percent rate. Earnings growth is becoming rare. Those companies that can grow earnings over the next year will be sought after. Their stock prices will rise. Those companies that cannot keep up the pace will be sold by investors and will see their stock prices drop. Welcome to the beginning of the end of this bull market. Brian B. Sullivan, CFA President & Chief Investment Officer, Regions Investment Management

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