By David Larrabee, CFA
In a recently published paper (“Growth Investing: Betting on the Future?“), noted valuation authority Aswath Damodaran examines the discipline of growth investing and, in so doing, challenges the notion that growth investors are simply risk seekers who ignore valuation.
Damodaran points out that growth stocks can dominate value stocks over shorter time periods, even though value outperforms growth over long time periods. Growth investing does best in periods of slow earnings growth — when it has scarcity value — and when the yield curve is flat or downward sloping, according to Damodaran. And active growth investors perform better against their passive counterparts than do passive value managers, suggesting that there is a bigger payoff for the successful growth investor.
Damodaran begins by noting the key difference between growth and value investors: Value investors tend to invest in mature, often underperforming firms with significant assets in place. Growth investors see their edge as the ability to assess the value of growth, generally in smaller, younger firms.
Growth investors can be active or passive in their approach. Damodaran breaks activist growth investing into two segments: venture capital and private equity. And based on the area of focus, he segments passive growth investing into three categories: small companies, initial public offerings (IPOs), and screeners. Some key takeaways:
- Venture Capital and Private Equity: There have been periods of time when venture capital and private equity have earned impressive returns. But when performance is adjusted for risk and survivorship bias, the long-term record is not so impressive. A diversified portfolio and a sound exit strategy are critical to success with these asset classes, as are an appetite for risk and a long time horizon.
- Small-Cap Investing: Growth investors who have the resources to perform the necessary due diligence and maintain a diversified portfolio and a long time horizon may be able to take advantage of the “small-cap effect,” the finding that small-cap firms outperform large-cap ones over time.
- IPOs: IPOs seem to be strong relative performers out of the gate, but the evidence is less compelling over long time periods. Damodaran suggests investors consider IPO investing as a supplemental strategy rather than an area of focus because of the “hot and cold” nature of the business, the tendency for winners to be concentrated in certain sectors, and the market savvy required.
- Screeners: Screeners can be indiscriminate and simply seek out companies with the highest growth rates and those selling at the highest P/Es. Or they can consider the P/Es relative to expected growth (PEG) ratios. As Damodaran points out, past growth rates are generally not good predictors of future growth, and relying on a strategy of simply buying companies with the fastest trailing or expected growth rates has been shown to be ineffective. Similarly, evidence does not support a strategy of buying high P/E stocks. PEG ratios are vulnerable to the uncertainty in estimating growth rates as well as the false assumption that the relationship between the P/E ratio and the growth rate is linear. Damodaran concludes that “while there are cycles during which growth screens yield excess returns, they are trumped over longer periods by value screens such as low P/E or low price to book value ratios.” He does note, however, that those who can consistently forecast growth more accurately than the market may have some success. Likewise, factoring in price momentum may also improve returns to a passive growth screen.
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