You can slice and dice stocks and stock mutual funds a thousand ways, but in the end the most useful explanation for what drives their prices boils down to two words: growth and value.
Growth investing is a matter of expectations. Investors buy Coca-Cola, for instance, expecting profits to grow steadily. Prudential Securities estimates that Coke's earnings will rise from 1993's $1.67 per share to $2.40 per share in 1995; and Prudential forecasts that the share price will rise as well, from $49 recently to $58 within a year.Growth stocks seldom seem cheap. But a growth investor reasons that what appears precious at 25 times the current year's earnings will look cheap at today's price a year or two from now.
Value stocks are underpriced bargains - in the words of Jim Floyd, senior research analyst for financial consultants Leuthold Group, "out of vogue, overlooked, disliked, cheap stocks that investors, institutions and analysts alike have given up on, have quit following and probably don't own."
Value investors love wounded discounter Kmart, which recently said it would close 110 stores and cut 6,000 jobs because of poor sales.
Leuthold sees Kmart as a blue-light special with an attractive price-earnings ratio, a delicious 5.5 percent dividend yield and the likelihood of solving its problems and turning earnings upward.
The easiest way to tell growth and value apart is to think in terms of "greater than" and "less than."
Growth stocks have rates of earnings growth greater than that of the norm. They also have P/E ratios that are greater than average and dividend yields that are less than the norm. They are plentiful in technology-rich industries and those that make consumer staples.
By contrast, value stocks share dyspeptic earnings outlooks, P/E ratios that are less than average and yields that are greater than the norm.
Value stocks are plentiful in cyclical industries, such as metals, and in financials, such as banks.
The growth investor's challenge is to avoid paying too much for that growth. A rule of thumb that some fund managers use is to buy at a P/E ratio no greater than the stock's expected earnings growth rate.
The value investor's job is to distinguish beaten-down stocks with bright prospects from those that richly deserve ignominy.