Does Growth Matter?

by: AAII

Is growth important to a rising stock price? My guess is that if I were to ask this to a random set of investors, the answer would absolutely be yes.

Growth makes a good story. Winners are preferred to losers and, when it comes to companies, winning is associated with growth. A company that is growing profits, or is expected to achieve strong earnings growth in the future, is often a company that attracts attention. Growth can put a stock in the news and it can attract investors. Growth can even lead to higher valuations.

But does growth make you money? The answer may surprise you.

A portfolio of large-cap growth stocks held from 1928 until 2011 would have realized an annualized return of 8.7%, based on data from the Ibbotson SBBI 2012 Classic Yearbook (Morningstar, 2012). This may seem like a good return, until you consider that holding a broad universe of all large-cap stocks would have earned you an annualized return of 9.8%, and a portfolio of value large-cap stocks achieved an annualized return of 10.8%. The same performance disparity appears when small-cap stocks are analyzed: growth lags both the all and value categories.

Think I'm looking at too long a period? James O'Shaughnessy ran the numbers from 1964 through December 31, 2009, in "What Works on Wall Street, Fourth Edition: The Classic Guide to the Best-Performing Investment Strategies of All Time" (McGraw-Hill, 2012). He concluded, "There's very little difference in buying the stocks with the biggest annual gain in earnings and buying a broad universe like all stocks."

Data from the stock screens on AAII add even further evidence. When editing Joe Lan's article on analyzing growth rates, which you will find in this month's AAII Journal, I looked to see how many of the top 10 AAII strategies ranked by risk-adjusted performance required a minimum level of growth. The answer was just one: O'Neil's CAN SLIM. The rest either didn't require a minimum level of growth or, in the cases of the Stock Market Winners screen and the Value on the Move-PEG with Estimate Growth screen, simply required earnings per share growth without specifying a minimum rate of growth.

There is a very simple reason why this is the case. Strong growth or the expectation of future strong growth leads to high expectations. High expectations in turn lead to high valuations. When the growth expectations are not met, the stock price tumbles. This is a cycle that has played out over and over, and will continue to occur in the future as long as investors allow greed and hope to drown out what historical data shows.

I'm not anti-growth; quite the opposite. The simple presence of inflation requires companies to grow revenues, earnings and cash flow. Growth is also required if a company wants its stock's price to rise. After all, one-half of the price-earnings (P/E) ratio is earnings and if profits don't rise, either the price will fall or the ratio will rise. What I am pointing out is that you should not overpay for growth. Over time, the market rewards those who buy good companies with attractive valuations, and punishes those who overpay for strong growth.

Food for thought the next time someone wants to talk to you about a company with a great growth story.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.