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Growth stocks don’t grow: Cannon

13 Jul 10          

Geoff Blount, CEO of Cannon Asset Managers, writes that whilst some companies carry the title “growth stocks”, the evidence shows that, despite this name, these firms don’t grow their earnings faster than the market.

To clarify the terminology, growth stocks refer to popular shares that investors bid up onto high price-earnings multiples in the expectation that they will have earnings growth that is higher than the market – often much higher. 

Examples of growth stocks include technology firms in the late 1990s; South African construction companies three years ago; resource stocks two years ago; the “defensive” medical companies, food retailers and gold stocks of last year; and current favourites such as Naspers, Capitec and Aspen.  However, time and again, investors’ high expectations of growth stocks are met with disappointment.  By contrast, it is the unloved, out of favour, low price-earnings stocks that actually grow earnings ahead of the market. 

This is evidenced in the chart below, which captures the results of a study of 10,000 global stocks over a 35 year period.  The study examines two aspects of investment results, namely the relationship between price-earnings ratios and investment returns; and the relationship between investment returns and earnings growth.  

The results deliver two findings that, to conventional wisdom, are surprising.  First, stocks on high price-earnings ratios, that is growth stocks, underperform the market.  By contrast, unloved value stocks on low price-earnings ratios outperform the market.  Second, a strong explanatory factor of this result is earnings growth.  Put simply, growth stocks experience earnings growth that is slower than the market and out of favour value stocks surprise by delivering faster-than-market earnings growth.  

To illustrate the evidence more fully, the basket of shares belonging to Quintile 1 are the most expensive twenty percent of stocks based on price-earnings ratio.  Quintiles progress through increasingly cheaper baskets, so that Quintile 5 carries the cheapest twenty percent of stocks.  The first (green) bar associated with each quintile shows the average annual investment return, measured over five years, relative to the global equity market.  From this, we have the first result of the study.  Specifically, the expensive growth stocks of Quintile 1 underperform the market by an average 4.7 percent per annum

Consistent with this result, modestly expensive growth stocks also underperform.  By contrast, the “deep value” stocks in Quintile 5 outperform the market by 9.8 percent per annum.  In this vein, the “shallow value” stocks of Quintile 4 also outperform.    This result evidences the “value premium” in global equity markets.  

Conventional wisdom holds that the value premium exists because investors are buying inherently riskier businesses and that they are being rewarded for taking this risk.  However, the second result of the research challenges this view.  Specifically, the results of the study show that extra returns are highly correlated with – and we argue driven by – earnings growth. 

This result is evidenced by the depth and height of the second (grey) bars which measure earnings growth from each basket of shares relative to the market over five years.  The evidence is convincing.  “Value” shares outperform because of stronger-than-market earnings growth and “growth” shares underperform because of poorer-than-market earnings growth.  

One explanation for this result is that value stocks’ earnings start on a low base (hence their unpopularity and deep value characteristics).  So, the argument goes, it is easier for them to enjoy higher rates of growth.  Equally, companies that have generated high rates of earnings growth in the recent past (explaining their popularity) will find it increasingly difficult to maintain this trajectory.  Consequently, whilst they establish a reputation for growing earnings faster than market, this is hard to sustain.  The evidence demonstrates that their earnings ultimately disappoint investors – and that this happens within a relatively short time frame of just five years.  This is not to say that all high price-earnings stocks disappoint – some go on to deliver phenomenal earnings growth.  But these businesses are a minority amongst growth stocks. 

By the same token, not all out of favour value stocks recover to shower themselves in success, some fail or just disappoint.  However, these underperformers are a minority.   Further, investors in these value stocks get a “double whammy” – not only do they participate in stronger earnings growth into the future but they also enjoy expansion of the multiple applied to the stock.  To explain, the price-earnings multiple increases as sentiment towards the company improves, meaning the company’s share price increases faster than earnings growth. 

But if this is such an obvious investment strategy, why isn’t everyone following it?  The reason is simple: from an emotional standpoint, it is a very difficult strategy to follow, more so in the case of deep-value shares where the greatest opportunity resides.  Despite the overwhelming evidence, investors prefer to hold recent winners and cling tightly to “popular” stocks.  

Portfolios of value shares require patience and the emotional willingness to look different to the market, as well as accepting a different shape of performance to the crowd, something most investors do not have the ability to stomach.

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