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Growth Eh?

Growth is what it's all about for investors. Every investor wants to see their portfolio grow and many attempt to generate wealth by buying growth companies. At first glance, it seems to be a simple matter to buy companies that have grown the most and, therefore, are likely to continue growing. Regrettably, as with many simple investment concepts, selecting growth stocks is fraught with difficulty.

With the view that past equals prologue, let's look at what would have happened to an investor who bought companies that grew the most in the previous year. This is sort of like the Dogs of the Dow approach except that instead of buying good dividend yield the growth investor buys stocks with the largest earnings-per-share growth in the prior year. The investor holds these prior year growers for a year, sells them, and then buys the new crop of growth stocks. How would such an investor have fared? Not including the corrosive impact of taxes, inflation, and commissions this approach was not fruitful from 1952 to 1996 according to James O'Shaughnessy . From 1952 to 1996 the top 10% of earnings-per-share growth stocks returned an annual compound return of 11.92% whereas the lowest 10% of earnings-per-share growth stocks returned 12.02% annually. The average stock did better than either extreme with a 13.35% annual return. Obviously, picking stocks based on one-year earnings-per-share growth was not worthwhile.

Perhaps longer-term growth is more profitable? Thanks again to Mr. O'Shaugnessy we can answer this question by considering the purchase of stocks each year which experienced the best earnings-per-share growth during the past five years. Again the investor swaps stocks each year to hold the latest batch of high growers. From 1952 to 1996 the five-year growth strategy yielded an annual return of 10.80% for the top 10% of growth stocks. On the other hand, the lowest 10% of five-year growers provided a 12.41% return and the average stock 12.91% annually.

What is going on with growth stocks?

To some extent this question is answered in the Tweedy, Browne report Great 10-Year Record = Great Future, Right?. The report takes an academic look at growth investing and I've reproduced two of its startling tables. In Table 1 stocks are placed into ten equal groups. The stocks with the highest past five-year sales growth in group ten and those with the lowest past five-year sales growth in group one. Subsequent five-year sales growth is then determined. Regrettably, a record of past sales growth is only a weak predictor of future sales growth. Turning from sales to earnings, Table 2 provides evidence on earnings-per-share growth. Here past strong earnings-per-share growth is a poor predictor of future earnings growth and poor growth appears to bode well for future growth. With this evidence in hand, it is little wonder that buying past growth turned out to be a poor strategy. Past sales or earnings growth simply does not predict future growth.

So what are we faced with? First, it appears that growth in sales and earnings is not easily predictable. If anything past poor earnings growth appears to indicate better than average future growth. Armed with this knowledge, investors can look with some skepticism on stocks with a strong record of growth. Other investors have probably noticed the growth trend and bid up prices accordingly. With a particularly long record of growth it seems likely that investors become overconfident of a rosy future and prices rise too high. The result is that stocks with a long-term growth record, as a group, tend fare worse than the average stock. In the end, it is better for investors to forget about past growth when selecting stocks.

Tables

Table 1
Does Past Sales Per Share Growth Predict Future Sales Per Share Growth?
Companies Ranked on Past Sales Per Share Growth Rates, 1967-1991
Low High
1 2 3 4 5 6 7 8 9 10
Growth Rate of Sales per share over the past 5 years
-18.5% -1.8% 2.3% 5.0% 7.1% 9.0% 11.1% 13.6% 17.7% 31.7%
Growth Rate of Sales per share over the next 5 years
5.7% 5.2% 5.4% 5.5% 6.3% 6.9% 7.4% 7.8% 8.9% 7.7%
Source: Tweedy, Browne Company


Table 2
Does Past E.P.S. Growth Predict Future E.P.S. Growth?
Companies Ranked on Past E.P.S. Growth Rates, 1967-1991
Low High
1 2 3 4 5 6 7 8 9 10
Growth Rate of Earnings per share over the past 5 years
-38.4% -7.4% -0.1% 4.4% 7.8% 10.9% 14.3% 18.5% 25.0% 51.1%
Growth Rate of Earnings per share over the next 5 years
23.1% 9.2% 6.3% 5.7% 4.9% 5.5% 5.9% 7.0% 6.2% 5.3%
Source: Tweedy, Browne Company


Sources

What Works on Wall Street, Revised edition, ISBN 0070482462

Tweedy's reports can be found at http://www.tweedy.com/content.asp?pageref=reports

First published in November 2002.

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