Why We Like Growth At A Discount

10/22/2012


When we look at a new stock for potential purchase, recent growth rates for sales and earnings are among the first things we consider. Yet our research shows that shares of fast-growing companies have not outperformed over the past two decades — a conclusion supported by academic studies that go back much further.

We divided S&P 1500 Index stocks into 33 baskets based on the latest quarterly per-share-profit gain, then determined average forward 12-month returns for each of the 33 baskets. We repeated that process on a monthly basis, and the charts below show the average return for each of the baskets in the 202 rolling 12-month periods since 1994.

Shares of companies with the best earnings momentum have not outperformed. The same is true for sales momentum, with rapid growers neither outperforming nor underperforming meaningfully, on average.

So, given the mediocre returns of rapid growers, why do we place such importance on recent sales and profit growth? The answer is that we are always measuring growth relative to the price we are paying for a stock. While rapidly growing companies tend to deliver above-average growth in the near future, they also tend to command above-average price/earnings and price/sales ratios.

Still, while history suggests you can't beat the market by loading up on shares of fast-growing companies, that does not mean historical growth rates have no predictive power. By combining growth rates with valuation ratios, history suggests you can tilt the odds in your favor.

Consider the bar charts below, which use our 33-basket methodology. The top two charts show the results of two back-tested strategies: (1) buying stocks with the lowest price/earnings ratios; and (2) buying stocks with the best combined scores for P/E and per-share-profit growth in the latest quarter, a strategy that favors cheap stocks with earnings momentum.

Based on absolute returns, the simple low-P/E strategy is superior, especially at the extremes. But the combination strategy does a better job of predicting future returns for the full spectrum of stocks — and is far less volatile. Indeed, based on the standard deviation of the top three baskets, the combination strategy was 25% less volatile.

Our Overall Quadrix® score is based on a similar insight. Stocks with the best Value scores have delivered strong historical returns. But by combining Value scores with scores for Momentum, Quality, Financial Strength, Earnings Estimates, and Performance, our Overall score delivers the best of both worlds — fundamentally superior companies with modestly valued shares. In fact, the top three baskets based on Overall score delivered slightly higher returns than the top three baskets on Value, even though the top Overall scorers were far less volatile.


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