It's hard to say what's more depressing to long-term growth investors: the failure of blue-chip growth stocks to hold their ground after the bubble popped in 2000 or the way these stocks have underperformed in the rally that began on March 11.
Here are the three-year average annual returns on some classic growth stocks:
, down 7.8% a year on average;
, down 8% a year;
, down 9.5% a year;
, down 23.8% a year;
, down 29.2% a year.
And how have these blue-chip growth stocks performed as the market has rallied this year? From May 1 through Aug. 15, the
has climbed 15.6%. Microsoft is down 0.7%; Gillette's up just 4.9%. Home Depot has bettered the Nasdaq with a 22% gain. But Coke trails at 11.3% That's as good as it gets. Wal-Mart is up just 3.9%.
It's enough to make investors throw up their hands and ask, "Is this the end of blue-chip growth stocks?"
The answer to that, as it is to so many questions in this market, is this: It depends. And it depends on which of the four categories of blue-chip growth stocks the stock we're talking about falls into: Is it simply an out-of-favor growth star, a growth-star reset, a growth-star impostor or a cooling growth star?
Let me describe each category. Then, I'll assign a few well-known growth stocks to each.
Out-of-Favor Growth Stars
These stocks cycle in and out of favor with investors. For a time, perhaps years, small-company stocks will outperform large-company stocks, and then for a time, large-company stocks will lead the market. Right now, steady growth stocks aren't in particular favor with the kinds of investors who dominate the market because stocks with more volatility offer the potential for bigger rewards. Think of it this way: Over the last five years,
earnings per share have grown 15% a year. That average conceals some volatility, of course. In 2001, earnings per share fell 0.7% from 2000; in 2002, they grew by 25.6%.
But that's mild compared to the volatility in a stock such as
. Merrill Lynch's 1998 earnings per share dropped 38% from 1997. They fell 86% in 2001. But in 2002, earnings jumped 361%.
Granted, no investor would like to be downhill from that kind of volatility. On the upside, however, a stock that can rebound from a terrible year has considerable earnings leverage that a Pepsi lacks just because it is so much more consistent. With the stock market rallying on investor hopes for the kind of strong economic recovery that plays into Merrill Lynch's earnings leverage, it's not surprising that in that May 1 to Aug. 15 period, Merrill shares are up 30.1%, about twice the gain in the Nasdaq. Pepsi shares are up just 3.4%.
But investors who look not too far out can see a likely changing of the guard in 2004. Wall Street analysts project Merrill's earnings will grow 27.6% in 2003, and Pepsi's just 12.4%. Next year, Merrill's earnings per share are forecast to grow by just 7.5% and PepsiCo's by 11%.
Honestly, there's nothing wrong with these stocks that can't be fixed by the market tilting in their favor next year, as some indicators are now suggesting. Besides Pepsi, I'd put
American International Group
Johnson & Johnson
Procter & Gamble
in this camp. All have underperformed in this recent rally. A few even show losses. Talk about out of favor.
A lot of companies with amazing records of consecutive years of earnings growth have seen those streaks end. In most cases, the ends didn't have much to do with the recently concluded recession, but more to do with efforts to take advantage of the temporary weakness of competitors.
has grown earnings per share every year but one in the past 10 years. But 2003 is clearly going to be a very different story, with earnings per share already running a whopping 86 cents a share behind the $3.10 earned in 2002. The short-term pain is the result of the costs of State Street's acquisition of
huge global custody business. The deal has made State Street the largest custodian of financial assets in the world. Over the long run, the deal should bring even more growth to State Street. But 2003 definitely marks a reset year in the company's growth record.
Other stocks I'd put in this group include
AOL Time Warner
is this category's poster child. Not because the online business is slowing, and not because the company allowed its technology to grow old. And not even because America Online faces huge challenges from broadband Internet providers to its bread-and-butter dial-up business.
It's an impostor because, as recent accounting news has revealed, just about everything the company's critics have said through the years about how it used gimmicks to pump up its growth rate was absolutely true. The organic growth (that is, the internal growth from existing business lines) was never as robust as investors, including this one, believed.
AOL Time Warner isn't alone. I'd include
, which continues to use accounting that masks the true cost of acquisitions;
, which used pension-fund gains and other tricks to bolster growth; and
, which used acquisitions to make it appear its core business was growing.
Cooling Growth Stars
What growth rate can investors expect out of
, one of the great growth stories of the 1990s? Right now, Wall Street estimates that Cisco will average earnings-per-share growth of 14.9% a year over the next five years. That's impressive enough to put the company in a class with Pepsi and Pfizer.
But it's small potatoes compared to the company's past growth rates. In 2000, the company's earnings-per-share growth rate for the previous five years stood at 33.6%.
So which is it? Will Cisco grow like Pepsi or Pfizer in the next five years? Or will it resume the growth of its heyday? The market is clearly pricing the stock for the latter possibility. Pepsi trades at 22.7 times trailing 12-month earnings and 20.9 times projected 2004 earnings per share and Pfizer at 29.1 times current earnings and 18.8 times forward earnings. Cisco trades at 36 times trailing 12-month earnings and 27.8 times fiscal 2004 earnings.
The problem with Cisco isn't that 14.9% annual earnings growth is shabby. If the company delivers that growth rate, I'd class it with the other great blue-chip growth stocks. But the stock isn't priced for that kind of growth. Instead it's priced for a resumption of past growth rates. And I'd say that's extremely unlikely.
, Microsoft and
are three stocks that trade as if old growth rates are right around the corner.
The problem isn't limited to technology. What's the likely future growth rate for Coca-Cola, Gillette,
? I think these companies are likely to better their recent sluggish performances, but I certainly wouldn't buy them at prices that assume a return to past growth rates.
That's my backward look at the challenges and problems facing the blue-chip growth stocks on which investors have come to rely.
Jim Jubak appears Wednesdays on CNBC's "Business Center" at 6 p.m. EDT. At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: American International Group, Microsoft, Pepsi, Pfizer and Sysco. He does not own short positions in any stock mentioned in this column.