Blinded by growth

This article focuses on the idea of investing in growth.  People often get excited about companies or geographies that are growing rapidly, and their excitement leads them to invest in securities representing these growing entities.  The first point that the author makes in the article is that there does not seem to be any correlation between economic growth and equity returns.  Why doesn't this seemingly intuitive correlation exist?  The three main reasons posed in this article are:

  1. Companies benefiting from the economic growth of one country are often based in another country.
  2. The largest companies in most countries tend to sell their goods and services in the international market place, resulting in isolation from local markets.
  3. When growth prospects seem high investors are willing to pay a premium, and they may be over paying.

The idea of buying growth securities is explained by the greater fool theory; a person may realize they are a fool for buying a stock with a P/E of 100, but they expect that a greater fool will buy the security for more at a later date.  To illustrate the dynamics of investing in a growth stock we can look at the following equation representing the return for an investor of a company that does not pay a dividend:


g is the growth of EPS.  This relationship shows us that positive earnings growth will have a positive impact on returns, but if the P/E changes in the opposite direction, this positive effect will be neutralized.  The example of Google between 2006 and 2010 is used; the company had earnings growth of 358.8%, but investors only received a return of 7.3%.  The reason for this disparity is the decreasing P/E.  In 2006, the P/E was 82.6.  This high value reflects the market's high growth prospects for the company - it comes back to all available information being reflected in the price of a security.  In 2010, the P/E had dropped down to 19.3, a reflection of much of the expected growth having been realized.  The problem for investors is that the price was so inflated with excitement in 2006, that it ate away much of the opportunity to partake in the growth of earnings.

The moral of the story here is that although growing companies can offer great prospects for investors, it is extremely important to assess how much is being paid to partake in the growth.  If the premium is too high, returns will be diminished.

The direction of the article is clear, and in line with my own beliefs on investing.  There is an inherent disadvantage to investing in growth stocks and an inherent advantage to investing in value stocks.  Growth stocks tend to be well known in the media and are companies trading with high P/E, P/B, or P/CF multiples due to their potential for growth, and value stocks are less interesting and exciting and have modest potential for growth resulting in them having low multiples. Historically, it has been shown that value stocks produce superior returns to growth stocks, a phenomenon known as the value effect.

It would make sense that the value effect is just an expression of the increased risk investors face when investing in value stocks, but the author argues that value stocks are historically less volatile than growth stocks.  Other arguments are also made by the author in favour of value investing, but he goes on to discuss that it is easier said than done to invest in out of favour securities.  This comes back to sentiment and psychology.

In conclusion, although it is more glamorous to invest in well-known and exciting companies with great growth prospects, the investor has been historically proven to be better off investing in less glamorous value companies.

(Link to paper)