Value stocks are usually companies that have a long record of success.
Definitions vary, but value stocks typically trade at average or below-average price-to-earnings (P/E) ratios and often pay dividends. Few companies start off as value stocks.
In a typical lifecycle, a stock might go from a hot IPO to a growth stock to a value stock. This cycle recognizes that growth in earnings should slow as a company grows its sales.
In theory, small companies can more than double sales every year for at least several years. This might involve increasing revenue from $5 million to $10 million to $20 million and then $40 million. Earnings per share (EPS) might grow at an even faster rate, on a percentage basis, as the company benefits from economies of scale.
Large companies, like Exxon Mobil Corporation (NYSE:XOM), have a more difficult time increasing their sales. With almost $400 billion in sales over the past 12 months, no one believes that Exxon could double sales growth every year for the next four years. Because growth slows with size, large-cap stocks like XOM tend to trade at lower P/E ratios than rapidly growing small-cap stocks, and they tend to offer their investors dividends to compensate for the slower growth.
Lifecycle transitions of a stock are not clearly marked, nor are they always permanent. It is possible for a value stock to enjoy rapid growth for a time if the company introduces a new product or a competitor leaves the industry. Although it is difficult to know when a transition is underway, we can often tell what stage a company is in based on its fundamentals. We can also spot where an industry or sector is in its lifecycle.
Solar energy is, perhaps surprisingly, a value sector. This is still an industry in its early days with seemingly unlimited growth potential, but some of the leading companies in the industry have a below-average P/E ratio. One of the largest companies in the sector, First Solar, Inc. (NASDAQ:FSLR), reported more than $3 billion in sales in the past 12 months and trades at a P/E ratio of only 10.6. Analysts expect to see sales growth of less than 5% next year and a decline in earnings.
There is still room for growth in the sector, but growth is expected to be fairly slow. Analysts expect industry growth of about 10% a year for the next five years. That is the type of growth typically seen among value stocks.
One advantage of value stocks compared to growth stocks is that value stocks generally have less risk than growth stocks because they trade at lower P/E ratios. That is true of the solar power sector.
The average P/E ratio of the holdings in Guggenheim Solar ETF (NYSEARCA:TAN), an exchange-traded fund (ETF) that tracks the sector, is only 13.4. This is below the average P/E ratio of stocks in SPDR S&P 500 ETF Trust (NYSEARCA:SPY), which is 14.8, and well below the average P/E ratio of the more speculative stocks in the iShares Russell 2000 Index (ETF) (NYSEARCA:IWM), which is 19.2.
TAN is the top-ranked U.S. sector ETF in my 26-week rate of change (ROC) system. The system is currently holding iShares Dow Jones US Aerospace & Def.ETF (NYSEARCA:ITA) and only sells when a current holding falls out of the top five ranked ETFs. This rule is designed to minimize the amount of trading required.