Beware the lure of go-go growth stocks; Rewards for successful investors are high, but hard to reach

February 26, 2014 5:02 pm

Beware the lure of go-go growth stocks

By John Authers

Rewards for successful investors are high, but hard to reach

US stocks’ long rally has lasted almost exactly five years. The S&P 500 has again hit all-time highs this week. Even the Nasdaq index is showing signs that it might be able to regain its high from 2000.

So can growth stocks possibly make sense? They were last in vogue when the Nasdaq peaked. While they had a decent run during the current rally, history shows that value stocks outperform in the long run. This makes it look as though growth stocks’ chance to shine has already passed, unless the market “melts up” as it did in 1999 – not a possibility that should make anyone happy.

The idea behind growth investing is to look for companies that will grow in the future. The justification for this is that investors persistently underestimate growth opportunities if they have not been proved yet. That yields a premium to those who are confident about growth.

In bad times, growth is in short supply, and so its price goes up. Meanwhile “value” stocks – that look cheap according to their fundamentals – are plentiful in bad times. Therefore, companies that raise their earnings in a tough environment will prosper disproportionately.

That is much what happened in the past five years. As predicted, growth beat value during the crash and in its aftermath. Since world markets peaked in October 2007, the MSCI World Value index has dropped about 8 per cent, while the equivalent growth index has gained 10 per cent. There is a similar pattern for the US, where the Russell 3000 value index is up 10 per cent, against 38 per cent for the growth index, over the same period.

“Melt-up” might happen

The dreaded “melt-up” might yet happen. The return of corporate acquisitions at nosebleed valuations, such as Facebook’s $19bn acquisition of WhatsApp, is uncomfortably reminiscent of 1999. But absent that, what is the case for growth?

Nick Thompson heads US equities strategies for Janus, arguably the world’s most famous growth investor. Its Janus 20 fund, which buys only 20 large-cap growth stocks at a time, gained more than 60 per cent in both 1998 and 1999. But in the decline that ensued, it fell 65.7 per cent against 40.6 per cent for the S&P 500. Over time this bumpy ride has delivered strong returns, outpacing the S&P by almost 2 percentage points a year since 1995.

Mr Thompson’s argument for growth is cogent. First, the gap in valuations between growth and value stocks is reasonable. According to MSCI, growth stocks trade for 1.38 times book more than value stocks. This is in line with the norm for the past decade. In 2000, the gap was more than five times book.

Further, he argues that companies with disruptive technologies can be identified, and that their ability to capture market share has not been priced in. Finally, he contends that while the market is not cheap overall, it is cheap enough to allow gains for stocks whose earnings grow.

Janus remains true to the investment research methods it publicised in its television advertising back in the 1990s. Rather than look at company accounts, its analysts gauge changes in the real world to try to spot where disruptive changes are afoot. This leads to sectors such as online retailing, or treatments for Hepatitis C. For a glorious statistic, look at the proliferation of software code in relatively simple devices. In the early 1980s, space shuttles went into orbit with the benefit of only 500,000 lines of software. Now, the average luxury car is crammed with 100m lines. That suggests an opportunity for companies that make sensors and microcontrollers.

Enormous rewards

Against this, however, there is a welter of evidence that the odds are stacked against growth investors. A recent fascinating report by the HOLT team at Credit Suisse lays bare the problem. The rewards for anyone successfully predicting which stocks’ earnings will grow are enormous. Buying the top 40 per cent of companies for earnings growth, while shorting the bottom 40 per cent yields a return of 11.56 per cent a year.

But this performance was so impressive only because the market, in aggregate, had failed to see such strong earnings growth coming. When Credit Suisse identified companies that were implicitly valued on the basis of strong earnings power, and divided stocks into four groups according to their market share and their growth, it found that “Cash Cows” – slow-growing companies with a high market share – performed best. The worst performance was by “Question Marks” – fast growing companies with a low market share.

These findings held true even when Credit Suisse divided companies according to whether their shares were expensive or cheap. Even when distinguished by price, growth lagged behind value.

Ultimately, value’s superiority is simple. It requires looking at things as they are. Growth requires predicting the future.

There will certainly be rewards for those who can do that. But growth investing will be a difficult way to make money, even if the market stages a repeat of 1999.