Saturday, May 02, 2015

high growth or low growth?

When you ask most investors for their favorite stocks, you'll rarely hear them share blue chip names like Johnson & Johnson, Kraft Foods or WalMart. Instead they will tell you about some amazing growth stock that will be the next Google, Microsoft or Apple.

These investors believe that by simply buying stocks with the greatest earnings growth potential that they will make money. Sadly our research clearly shows this not be true...not even close.

Unfortunately our research details, beyond a shadow of a doubt, the vast underperformance of most growth stocks over the past decade. Here are the results:

*The study had a 4-week rebalancing of stocks between 4/2005 and 3/2015

Stocks with the lowest projected growth rates actually generated the highest return of +9.0% per year. Each level of additional earnings growth came with decreasing levels of profits for investors. As we look at the most aggressive stocks, with 30%+ expected earnings growth, we find an embarrassing loss of -1.2%. This begs an obvious question:

Why Don't Most Growth Stocks Pan Out?
The early investors in growth stocks usually do quite well. They take the early risk when almost no one has heard of the company. As the company bangs out earnings surprise after earnings surprise it gains more investor attention and a much higher share price.

However, at some point the company will be "priced for perfection". Meaning that the PE gets too inflated as people are so sure that the good times will just keep rolling (think of a mini version of the late 1990s tech bubble).

Unfortunately the exceptional growth rarely holds up over time. At some point, as the company tries to expand so rapidly, it will stumble. Even if that just means going from a 40% growth rate to a 30% growth rate. On the surface, 30% still sounds great...but not to the investors who expected 40%+ and paid up for that premium. So naturally the stock will tank. And tank fast.

I'm sure you've had a few of these stocks in your portfolio over the years. So I don't have to remind you how quickly the losses add up. That, in a nutshell, is the danger of investing in growth stocks.

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