Recessionary Equity Strategies: Still Going for Growth

by: Marc Gerstein

Traditionally, growth is the last thing investors should consider when formulating recession-oriented investing strategies. According to the stereotype, growth stocks tend to be over priced and over hyped, and hence most vulnerable to steep declines during market downturns. Clearly, we've all seen many instances in which events conformed to that image. But it's not growth per se that's the problem. Those who focus on the basics rather than glamour can find an ample number of growth strategies that are viable even in bear markets.

Sticking to basics

Strictly speaking, without growth, it would be hard to make a case for any kind of equity investing in any kind of market. after all, many stocks pay no dividends and many that do pay have yields which fall shy of even the highest-quality segments of the fixed-income market. Without expectations of growth, what else is there?

Unfortunately, the image of growth investing long ago separated from that core notion and came to be dominated by something quite different; the casino-like segment of the equity community.

Sometimes, growth gets associated with pure hype, as we saw nearly a decade ago when stories of future glory attracted many notwithstanding the absence of reasonable revenues or profit support. Other times, and more frequently, the label is associated with the sometimes lucrative but often erratic practice of acting as if the growth achieved and/or expected in a single period is all one needs to consider.

Basic growth, the sort that justifies investing in equities as opposed to fixed income, is a different sort of animal. It's real. In other words, it's measurable through actual financial performance as opposed to mere story-telling. And it's reasonably likely to be sustainable; i.e., persisting beyond a single quarter.

It can be dull as dishwater (as you'll see in the lists below), since the hottest stories of the day often falter in one or both of these criteria. Some may find this surprising. One of the reasons why so many investors shun growth during down markets is because these stocks are believed to be over-priced. But reality doesn't necessarily match the image. Table 3 below lists 20 stocks that pass a growth model I'll soon discuss. The companies have annual growth rates averaging 34.3 percent and 31.7 percent over the past three and five years respectively, and an average projected future annual growth rate comes to 14.9 percent. But the average trailing 12 month P/E is 20.7 and the average PEG of 1.28. Those aren't necessarily bargains, but they can hardly be characterized as exorbitant.

There are many things that make for hype-able stories, but there's reason to suspect that bona-fide, sustainable growth may have been left off the list (or to the extent it's there, its presence may be little more than a coincidence).

Measuring growth

I created a simple growth-oriented ranking system using the following equally-weighted factors.

  • EPS Growth, latest quarter
  • Sales Growth, latest quarter
  • EPS Growth, trailing 12 months
  • Sales Growth, trailing 12 months
  • EPS Growth, last 5 years
  • Sales Growth, last 5 years
  • EPS Growth, last 10 years
  • Sales Growth, last 10 years

The balance between Sales growth and EPS growth is designed to mitigate potential oddities that might impact either data stream. Sales trends could be distorted by acquisitions and divestitures. EPS trends could be distorted by any number of one-time charges or income items. The presence of sales in this model also makes it hard for companies to create the appearance of growth by over-reliance on cost-cutting (i.e. boosting EPS despite stagnant business trends).

Use of five- and ten-year periods will eliminate a lot of Johnny-come-lately type firms. It's true some legitimate growth companies will be knocked out. But these are the ones whose shares are most likely to be over-hyped and which have the most to prove in terms of staying power. Hopefully, we'll get a dynamic like this: eliminate seven bad situations, and accept elimination of three good ones as a reasonable tradeoff.

Use of trailing 12 month and latest-quarter comparisons represents an effort to avoid getting too carried away with the long term. Hopefully, these criteria will eliminate companies that grew well over a prolonged period but fell off a cliff in the most recent past.

Finally, it's important to note that since this is a recession-oriented strategy, the above ranking criteria are being applied only to the defensive-stock universe (drawn from the utility, healthcare and consumer areas) described in a recent article.

I backtested the approach using the advanced back-tester to create hypothetical portfolios at the start of each week between 3/31/01 and 9/13/08. All were then "held" for only four weeks. In other words, portfolio 1 ran from day 1 through day 28; portfolio 2 ran from day 8 through day 35, portfolio 3 ran from day 15 through day 42, and so forth. The results reflect the average performance of the 390 four-week portfolios thusly created.

Table 1

Computations are for stocks with market capitalizations of at least $250 million Defensive Groups includes filters described in a previous article

The first two rows of Table 1 are interesting insofar as they suggest that in normal times, this growth strategy holds no special appeal. Perhaps we'd see better numbers if I used different factors and/or weightings. But based on other basic growth models I've seen over time, I'd suggest the answer is more structural than that. During good times, basic growth alone won't necessarily suffice. When the market is strong, above-average performance probably depends not just on owning companies that have been shown to be really good, but also on being in touch with day-to-day practical realities; i.e. what investors think is good whether or not those views hold long-term validity. Let's face it: in bull markets, we've seen plenty of people make good money with average or even bad stocks, since there's a large window of opportunity to take profits before the day of reckoning.

But the last two rows paint a very different down-market picture. Focusing on highly-ranked growth companies in defensive industries offers reasonable downside protection compared with stocks as a whole. However, row three indicates that this benefit comes not from growth but from use of the defensive-industry grouping.

Interestingly, the main benefits of the growth aspect of the strategy is the ability to narrow the defensive universe to an investable number of issues (20 in this case) and a reasonable balance between up-market versus down-market performance.

The appeal of this strategy is definitely not universal. It depends, instead, on one's individual attitude toward up-side versus down-side tradeoffs. But whatever the preferences of a particular individual, one thing is clear. Growth, real as opposed to hyped, poses no special dangers during bear markets.

Table 2 lists the stocks that currently fulfill this approach.

Table 2

More importantly, this is not the only possible growth strategy. Continuing on...

Middle of the road

In last week's article on recessionary-value strategies, we saw how we can benefit by looking at middle-ranked stocks, which, in that model, turned in a much better relative performance during down markets. The logic of considering the middle would seem to apply to growth as well, since upside extremes can be difficult to sustain over time.

Table 3 shows the results of a back-test based on picking middle-ranked growth stocks from among defensive businesses.

Table 3

Click to enlarge

Computations are for stocks with market capitalizations of at least $250 million Defensive Groups includes filters described in a previous article

The result here is about the same as what we saw from the mid-ranked value strategy.

Table 4 shows the stocks currently making the grade based on this approach.

Table 4


What we've seen here is that there is no reason to fear growth investing even during recessions. As it turns out the growth back-test results closely resemble those we saw from value and also somewhat similar to those we obtained from an earlier-discussed quality-oriented strategy.

So what we have, to this point, are three styles, each of which seems viable in recessions but none of which can stand as silver bullets. Given such a generally-even race, and the seeming tendency of the market to rotate from style to style (raising past-performance-future-results questions in connection with all of these studies), it seems reasonable to wonder whether we might benefit from developing multi-strategy approaches that seek stocks that satisfy a variety of approaches.

The short answer is "yes." We'll dig into that next time.

The material herein, while not guaranteed, is based upon information believed to be reliable and accurate. Neither Prism Financial, Inc., owner of, nor Marc H. Gerstein, an independent contractor working with Prism (a) guarantee the accuracy, completeness or timeliness of, or otherwise endorse, the information, views, opinions, or recommendations expressed herein; (b) give investment advice; or (c) advocate the sale or purchase of any security or investment. The material herein is not to be deemed an offer or solicitation on our part with respect to the sale or purchase of any securities. Our writers, contributors, editors and employees may at times have positions in the securities mentioned and may make purchases or sales of these securities while this report is in circulation.