Any list of long-term stock market winners is dominated by companies that grew earnings per share (EPS) much faster than market averages. Therefore, the key to future portfolio success must be to buy stocks with the highest earnings growth prospects, right? Wrong!
If each year from 1986 to 2006 you had purchased the 20% of stocks from the 3,200 largest market capitalization public companies with the highest five-year EPS growth forecasts, your portfolio would have lagged the average stock by about 1.5% annually, while being much more volatile.
There are two primary reasons why stocks with high EPS growth forecasts tend to underperform:
1. Stocks with high growth expectations tend to have high current valuation levels—that is, high price-to-earnings (P/E) ratios. Stocks with strong earnings potential are typically well known, and investors are usually willing to “pay up” for potential growth.
2. High expectation stocks tend to deliver actual earnings growth far short of optimistic forecasts. When such stocks report negative earnings surprises, prices tend to fall and P/Es to contract.
Lower P/E stocks have tended to provide higher historical returns for any level of expected EPS growth. Interestingly, this effect is more prominent among value stocks with low EPS growth expectations than among growth stocks with high EPS growth forecasts. In other words, high growth expectation stocks with low PEG ratios still tend to underperform.
Building a portfolio of stocks with the greatest likelihood of outperforming the market over the long run is a process of tilting the odds in your favor. While there are exceptions to every rule, history suggests that buying stocks with high EPS growth forecasts or high P/Es is fighting the odds. Here are three useful rules of thumb:
1. Avoid stocks with P/E ratios above 25 (use EPS over the last four quarters from continuing operations before extraordinary items).
2. Avoid stocks with five-year consensus EPS growth rate forecasts above 25.
3. Avoid stocks with negative current EPS and five-year consensus EPS growth forecasts above 15%.
Perhaps the most practical lesson that can be taken from our “P/E vs. Growth” matrix is to ignore consensus five-year EPS growth forecasts altogether and simply emphasize buying stocks with low P/E ratios. While a diversified portfolio of low P/E stocks will not always outperform and definitely makes a bet on value stocks, historically such portfolios have outperformed the broad stock market and been simultaneously less volatile—not a bad combination.
By Greg Forsythe, CFA
Senior Vice President, Schwab Equity Ratings®
Schwab Center for Investment Research®
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