Money
Issue No. 11 - June/July 2003
Growth versus Value
Is there a free call option in Growth?
by Tony Catt
Over recent months, investors have continued to seek the safety of the more defensive value—oriented stocks, while the growth sector has continued to suffer a systematic de—rating of the high price earnings multiples it once enjoyed.
Consequently, it can be seen that a free “call option” is embedded in these stocks, as the market isn’t pricing in the growth that we believe they can achieve.
We have been anticipating that growth would rebound for some months now, though it hasn’t yet done so. We believe it is hard to see any further P/E compression occurring in the growth stocks, and that on balance, the positive factors supporting a rebound in growth (detailed below) outweigh the negatives.
Positive Factors
Valuations in the growth sector are no longer stretched, with the relative P/E premium of growth to value close to historical lows. The last time the relative P/E premium was this low was following the 1997 Asian crisis, and just prior to the previous growth boom. The valuation for growth looks even cheaper when the relative forecast growth is taken into account.
Money flows within the growth sector are now positive relative to value, previously one of the factors holding growth back.
Implied Risk Premium – The risk premium is the premium above a stocks forecast risk premium using the theoretical CAPM model. It therefore gives us an estimate of the additional risk the market prices into a stock above its cost of capital. Historically, there has always been a relatively high—risk premium priced into the value sector relative to the growth sector. However, currently there appears to be no risk premium being compensated for the additional risk. When the period of analysis is lengthened beyond three years, this conclusion becomes stronger.
- During the tech boom, growth stocks had a negative implied risk premium. The previous time this occurred was in 1994, which was also the start of the ...
