With the equity market looking decidedly cheap, not only on its own valuation history, but also against cash and bonds, the tag ‘growth stock’ has become something of a furphy. Trading on an average PE of 9x, stocks have been sold down to their NTA or franchise value with earnings forecasts ranging from -4% to +4% across the market.

Adding further to investor angst, while many defensive stocks now trade on larger PE multiples, perennial growth stocks are on PEs more reminiscent of value plays. And while their upside may not be what it was, they may still offer good growth, relative to the overall market.

However, investors are justifiably nervy about wading in on these stocks, fearing that any further signs of weakness could deliver more share price carnage. The same fate could also be metered out to any stocks that investors have paid more to acquire, especially if there’s any whiff of them failing to deliver on expectation

Given these market aberrations, Philip Pepe portfolio manager of the Macquarie High Conviction Fund expects survival mode to keep growth relegated to a bottom drawer priority for some time. And he says it could be another six months before sentiment starts valuing stocks on a more rational basis.

According to Pepe, what differentiates today’s bear market (from former ones) is investor fixation with not only the sustainability of future growth, but also how that growth will be funded. Incitec Pivot (IPL) illustrates why. In the absence of bank funding the fertilizer group, had to resort to equity financing to repay a $2.4 billion bridging loan.

And that’s after tripling its net profit after tax to $614.3 million and taking earnings per share to 61.4c. While 2009 is expected to be another boom year for IPL, investors were unnerved by management admission that earnings won’t be as dramatic as 2008, and this missive saw the share price head south.

So unless companies can issue their own equity like IPL, Pepe says many growth decisions – as mine stocks now realise – will remain indefinitely deferred. Unsurprisingly, Simon Bonourvrie portfolio manager with Platypus Asset management expects longer-term growth trends (that typically drive earnings higher) to remain marginalised until debt market funding conditions normalise.

He says investors who still crave growth should start by looking at the strongest players within targeted sectors, and then marry up key valuation metrics. These include: Strong earnings growth, sales growth, industry growth, the quality of products and services, plus quality and historical performance of management.

Equally revealing, adds Bonourvrie is the Price-Earnings-Growth (PEG) ratio that compares a stock’s price/earnings (P/E) ratio to its expected EPS growth rate. He says the aim is to get the PEG at the lowest rate (under a ratio of one) as possible (as is the case with Leighton Holdings on 0.9%).

So the lower the PEG (under a ratio of one), the greater the discount between the share price and EPS growth projections. Growth stocks typically have a PEG ratio greater than one because investors are willing to pay more for their expectant growth trajectory.

As well as steering clear of stocks requiring major refinancing within the next two to three years, Bonourvrie favours conservatively geared balance sheets (under 30% debt to equity) that make companies capable of enduring the credit crunch. “Companies with lower debt levels will be able to exploit opportunities and offer better pricing,” says Bonourvrie. “We’re currently seeing that with banks versus non-bank lenders, and the stronger players within retail are also exploiting their position.”

So do former growth stocks like Worley Parsons and Crown Casinos deserve to be trading at half their historical PEs? Well, no but Bonourvrie says it’s painfully clear investors aren’t prepared to pay a premium for them while they distrust consensus earnings forecasts. That’s why he says stocks that have held their PEs relatively well (due to perceived certainty of earnings) have been awarded a safe haven moniker.

But given their higher PE multiples, Matt Kidman of Wilson Asset Management says it’s the so-called safe havens that are most susceptible to downgrades. “That’s especially likely for consumer staples, medical stgices, healthcare and alcohol-related sectors where PEs have not fallen as far,” says Kidman.

He says investors could be better off acquiring stocks that were unduly punished amid recent downgrades. These include: Billabong, JB Hi Fi, Leighton Holdings, Computershare, Worley Parsons, and Crown Casino.

This is why Pepe currently has his radar out to acquire (former) growth stocks looking significantly oversold. And with finance and listed property sectors looking the most oversold, he says they might witness the biggest rebound on a one to three year outlook.

In an absolute sense, retail, healthcare and utility sectors are amongst those to have held-up relatively well. But Pepe reminds investors there’s no guarantee these will be the first to bounce when fundamentals return.

For investors still trying to capitalise on growth, he says the biggest question is – ‘how much growth is implied in the share price’? “If a stock that once traded on 15x is now trading on 5x there’s a lot of risk priced in,” says Pepe who expects his fund to outperform the S&P ASX 200 by 6% over the next three years. “So what levels of reward can you expect for that risk?”

“Safe haven” stocks susceptible to downgrade:

– Fosters
– Lion Nathan
– Woolworths
– Resmed
– Ramsay Healthcare
– Telstra
– Cochlear
– Primary Healthcare
– Healthscope