Growth Stocks Tend to Underperform: Here's a Better Path to Profits

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Includes: BLK, CSX, DOW, NTES, ROK
by: Steve Reitmeister

When you ask most investors for their favorite stocks, you’ll rarely hear them share a blue chip name like Johnson & Johnson (NYSE:JNJ), Kraft Foods (KFT) or WalMart (NYSE:WMT). Instead they will tell you about some amazing growth stock that will be the next Google (NASDAQ:GOOG), Microsoft (NASDAQ:MSFT) or Apple (NASDAQ:AAPL).

These investors believe that by simply buying stocks with the greatest earnings growth potential that they will make money. Sadly our research clearly shows this not be true…not even close.

In this article I will dispel the myth about investing in growth stocks just for growth's sake. Instead I am going to shine the light on a path that has more consistently paved the way to profits.

Research Says…

I know that many of your are still shaking your heads in disbelief. Certainly I must be joking, right? Unfortunately our research details, beyond a shadow of a doubt, the vast underperformance of most growth stocks over the past decade.

Here are the results.

Projected Earnings Growth Rate

*Annualized % Return

0 - 10%

+9.5

10 - 20%

+9.3

20 - 30%

+7.2

30%+

+1.3

Click to enlarge

*The study had a 4 week rebalancing of stocks between 1/7/2000 and 2/18/2011

Stocks with the lowest projected growth rates actually generated the highest return of +9.5% per year. Each level of additional earnings growth came with decreasing levels of profits for investors. As we look at the most aggressive stocks, with 30%+ expected earnings growth, we find an embarrassingly low +1.3% return. This begs an obvious question….

Why Don’t Most Growth Stocks Pan Out?

The early investors in growth stocks usually do quite well. They take the early risk when almost no one has heard of the company. As the company bangs out earnings surprise after earnings surprise it gains more investor attention and a much higher share price.

However, at some point the company will be “priced for perfection”. Meaning that the PE gets too inflated as people are so sure that the good times will just keep rolling (think of a mini version of the late 90’s tech bubble).

Unfortunately the exceptional growth rarely holds up over time. At some point, as the company tries to expand so rapidly, it will stumble. Even if that just means going from a 50% growth rate to a 40% growth rate. On the surface 40% still sounds great…but not to the investors who expected 50%+. So naturally the stock will tank. And tank fast.

I’m sure you’ve had a few of these stocks in your portfolio over the years. So I don’t have to remind you how quickly the losses add up. That, in a nutshell, is the danger of investing in growth stocks.

So What Does Work?

Certainly you could look at the stats above and conclude that stocks with lower projected growth rates generally outperform. That is true. But we can do a heck of a lot better than that.

The key is to find stocks that exceed expectations no matter the growth rate. Meaning that a stock that is expected to grow profits by 5% and ends up growing by 7%, will do very well. Ditto for a stock expected to grow 30% that ends up at 35% actual earnings growth.

I know on the surface it sounds like you need a crystal ball to predict which companies will beat their earnings projections. Gladly it’s actually much easier than you think because Len Zacks has done the hard work for you.

In the mid-1970’s Len Zacks realized that stocks that had big earnings surprises continued to outperform the market over the next several months. This is what academics call the Post Earnings Announcement Drift…(yes, I know it sounds more like a medical problem than a means in which to invest in stocks ;-)

But Len went a step further. He wanted to find indicators that would show him stocks more likely to have positive earnings surprises BEFORE they happened. If you could do that, then the odds of success were firmly stacked in your favor.

For the next several years Len worked feverishly to discover these indicators. Gladly for all of us he did find 4 leading indicators of future earnings surprises. Three of these measures are ways of looking at brokerage analyst earnings estimate revisions. The last being an analysis of past earnings surprises.

Each factor is potent by itself. Blending them together creates an almost unfair advantage for investors…that advantage is now called the Zacks Rank stock rating system which continues to significantly outperform the S&P 500. And yes, blending the Zacks Rank with high projected growth rates also produces attractive returns.

Take 5

This is where I share 5 of my favorite stocks that all have a coveted Zacks Rank of 1 (Strong Buys)

  1. Blackrock (NYSE:BLK): It’s quite simple. We have a 2 year bull rally moving towards a 3rd year anniversary. This has more investor dollars flowing to managed accounts. And those accounts are rising in value. This produces very healthy profit growths for companies like BLK and the party is not over yet.
  2. CSX Corporation (NYSE:CSX): Two very positive catalysts are combining to make this a very attractive investment. First, you have an improving economy which leads to more goods being transported. Second, rising oil prices make transportation by rail all the more attractive. No wonder CSX is making new highs.
  3. Dow Chemical (NYSE:DOW): An expanding world economy = consumption of more resources = higher demand for chemicals = rising profits for DOW = soaring share price.
  4. NetEase.com (NASDAQ:NTES): This leading Chinese internet portal and online gaming company continues to impress investors. Big pipeline of new product releases has many analysts excited about future growth prospects.
  5. Rockwell Automation (NYSE:ROK): The US industrial space continues to show the most impressive results and that is clearly of benefit to a main vendor to these firms like ROK. The latest quarter’s 18% earnings surprise put investors on notice that there is much to like about these shares.

Disclosure: I am long NTES.