As Growth Stocks Stay Weak, Some Smell Opportunity

In a typical bear market, most stocks drop somewhere between 15% and 40% from their previous highs. By that yardstick, the bear is already large and in charge on Wall Street--at least among formerly high-flying growth stocks.

Many of the small- and mid-size growth stocks that soared to record highs in the spring were crushed in the summer market sell-off and never fully recovered. In fact, many have been hammered further in recent months, despite their often-stellar earnings growth potential.

Not even the autumn decline in bond yields--normally an event that instantly revitalizes demand for growth stocks--has helped them this time. And now, with portfolio managers and individual investors squaring their books for year-end, the stocks are being further buffeted, to the extreme dismay of their true believers.

“This is bear market behavior,” laments Gary Pilgrim, whose Wayne, Pa.-based PBHG Growth fund is one of the best-known buyers of emerging growth stocks. The fund was up 21% between Jan. 1 and May 24. It is now up just 6% for the year.

For individual stocks, the damage has been far more severe. U.S. Robotics, a fast-growing maker of computer modems, has dropped 33% from its peak 1996 price; United Auto Group, a franchiser of auto dealerships, has also lost 33%; AccuStaff, a temporary-help service, is down 47% from its peak; software firm Cadence Design is down 17%.

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Many fund managers say their peers have simply relearned an old lesson about overpaying, even for sexy companies with above-average earnings growth. During the speculative frenzy for growth stocks in spring, price-to-earnings ratios (P/Es) on some of the issues reached 70 to 100 or more. “There were a lot of managers who said that high P/Es don’t matter,” said John Ballen, head of the MFS Emerging Growth fund in Boston. “They found out that they do matter.”

Other pros say growth-stock investors were victims of their own success. Hordes of investors rushed into the stocks in spring, merely playing the “momentum” game of chasing stocks that have already surged. When the July market pullback hit, the tide of momentum players reversed: The same investors who couldn’t get into the stocks fast enough when they were rising suddenly couldn’t get out fast enough when they began to sink. Fundamentals mattered little.

But some growth-stock veterans say enough is enough. Markets always overreact, in both directions. At some level the stocks should begin to appear undervalued relative to their earnings potential. Or as Pilgrim puts it, “If you thought the P/Es were insane last spring--and those aren’t my words--they’re a lot more reasonable now.”

Michael DiCarlo, manager of the John Hancock Special Equities fund in Boston, cites United Auto Group as an example. At its peak 1996 price of $35.25, the stock sold for 22 times analysts’ consensus estimate of 1997 earnings per share. Today, with the stock off one-third, the P/E on the 1997 estimate is 15. So a company whose earnings are expected to rise 50% next year sells for a lower P/E than the average blue-chip stock, whose earnings may be up 10% at best.

Of course, whether United Auto is really a cheap stock depends on whether it can produce the earnings Wall Street expects. Many growth-stock managers insist that, despite concerns about slower corporate earnings growth overall in 1997, their portfolios are filled with fast-rising young firms in hot market niches. In any economy, they note, some companies are always doing well.

Ballen, for instance, said executives from HFS Inc., the hotel franchiser and owner of the Century 21 real estate and Avis rent-a-car chains, assured him Monday that their business plan is on target. Wall Street expects HFS’ earnings to double in 1997 from 1996 levels. Yet the stock is off 28% from its 1996 peak, and its P/E on analysts’ consensus earnings estimate for 1997 is now 23.

Is that a bargain? With the average blue-chip stock’s P/E at 19 based on 1997 estimated earnings, Ballen points out that P/Es of many faster-growing stocks now aren’t too far from that benchmark. In a hot market for growth stocks, their P/Es should be far above that benchmark. When the stocks periodically go out of favor, as they have recently, Ballen said history shows that the closer growth-stock P/Es get to the market average, the more likely it is that buyers at those levels will be picking up tremendous values.

The caveat: If the growth stocks’ woes are just a precursor to a market-wide plunge, things will get a lot worse for the stocks before they get better.

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Getting Cheaper

How some recently high-flying growth stocks have fallen, and the stocks’ price-to-earnings multiples based on analysts’ mean estimates of 1997 earnings per share:

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Tues. Drop vs. 1997 Stock price ’96 high P/E Accustaff $20.25 -47% 24 Corporate Express 25.63 -45% 23 United Auto Group 23.75 -33% 15 U.S. Robotics 71.13 -33% 21 Cascade Commun. 62.13 -32% 56 Guess 13.00 -29% 8 HFS Inc. 57.25 -28% 23 Cadence Design 36.88 -17% 22 Reading & Bates 26.25 -16% 13 Ascend Commun. 66.00 -12% 44 S&P; 500 index 726.04 -4% 19

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All trade on NYSE except Corporate Express, U.S. Robotics, Cascade and Ascend, which trade on Nasdaq.

Source: IBES Inc.; Zacks Investment Research