Growth Stock InvestingGrowth investors expect to beat the market by focusing on companies with above average earning growth. Indeed, over long periods of time, share price is positively correlated with a company's earnings. Growth stock investing is a long term investment strategy. Let's first make a short stop at Growth versus Value Indexes (or just head straight to Growth Investing). Growth versus Value IndexesStock Market Indexes (S&P, Russell...) split the entire investment universe into Growth and Value. The market is wholly ranked based on a combined score of High Price/Book value and High Expected Growth: the top 50% is considered Growth, the bottom 50% Value.The underperformance of Growth indexes versus Value indexes may be due to this simplistic definition. Expected growth has often proven to be a poor forecaster of real future growth. Growth investing is a bit more complex than just looking at expected growth and Book value and many stocks classified as Growth by Indexes would not qualify as a good Growth investment. Said differently, you may do well with a Value Index Fund or ETF but you'd better build your own portfolio of stocks as far as Growth Investing is concerned. Back to Growth Investing Go back to TopMost academic studies and backtesting on Growth investing lead to about the same conclusions:
So what do we get? Mainly 2 Growth Investing strategies can be derived and have been successfully used. Strategy 1: if you can correctly estimate a company’s future growth and buy it when it is cheap, then Bingo. The master at this strategy is Warren Buffett: check this page dedicated to Warren Buffett Investing. It is probably THE best definition of Growth Investing. Strategy 2: If you don’t have any system to accurately estimate future earnings, then your main way out of Growth Investing is Value. Welcome to GARP: Growth At Reasonable Price. Let’s use the thematic stock screening approach to build GARP strategies Investing Universe Go back to TopMarket CapitalizationSmall/Mid Cap companies have higher room to grow than large cap so a bias toward small/mid cap can be used. If you're a conservative investor, then stick to Large Cap. Smaller cap suffers from larger Bid-Ask spread so it is best to add a liquidity test. Primary Theme Go back to TopA popular criterion in GARP Investing is the (Price/Earning)/Growth, or PEG that combines Value and Growth in a single parameter.Some studies have shown that simply screening companies with low PEG provides excess returns (See Growth vs Value Investing (PDF) by Roger G. Ibbotson and Mark W. Riepe and Growth Investing (PDF) by Aswath Damodaran from Stern university). A good thing with PEG is that a company must have positive Earnings and Growth for it to be calculated. Although the growth percentage is not useful by itself, positive growth is a plus in the short-medium term. Some consider that a PEG<1 is good, others put the threshold at 0.8. If you're a conservative investor, you may want to use a modified PEG that add the Dividend yield to the Growth Rate as follows: PE/(Growth+Dividend). This is not to penalize companies that pay higher dividends and usually exhibit lower growth. At the end of the day, total return is Growth plus Dividend so this makes sense. Some screeners, including MSN Deluxe screener, allows you to create your own screening variable so you can easily build this modified PEG. Because PE and Growth are highly sector specific, you may want to screen relative to sector/industry average PEG. Note: A GARP strategy that is gaining popularity is Greenblatt's Magic Formula Investing. Instead of using PE/Growth, Magic Formula investors can look into the PE/ROC (Price/Earning divided by Return on Invested Capital). Past Earning growth and future Earning growth estimates are of little help for Growth Investors. However, the direction of the growth is more predictive (David Dreman "Contrarian Investment Strategies: the next generation") so adding a criterion on improving Growth can be useful: for instance, you can use "Growth this year > Growth last year". Secondary Theme Go back to TopValuation ratios may be added even if PEG is used. For instance a company with PE = 50 and Growth = 60% will have a PEG<1 but you may be uncomfortable buying companies with PE = 50.Moreover high growth rates are unsustainable so limiting the PE to say 30 can be used. Since you use PEG in the Primary Theme, this will automatically eliminate high growth. Jim Slater uses PE<20 in The Zulu Principle. Ranking and Holding Period Go back to TopPEG is a prime ranking parameter.As in Value Investing, Relative Strength can be used as Ranking for Growth investors. While Relative Strength increases expected returns, it also increases volatility. Growth Investing (GARP) is a long term strategy and is therefore adapted to long holding periods (≥1 year). If Relative Strength is used as Ranking parameter, then holding period should be 1 year. Below 1 year, you're basically moving towards Momentum Investing which often includes earning growth acceleration. Sample Mechanical Growth Investing Screens Go back to Top2 simple Growth (GARP) screens are shown as example: Jim Slater's Small Cap Growth adapted from The Zulu Principle and James O'Shaughnessy's Cornerstone Growth from "What Works on Wall Street".Can you notice the inclusion of Value and Relative Strength in both screens? Value is very important in Growth Investing. Relative Strength allows to boost performance when holding period does not exceed 1 year. (*) Notes:
If you have MSN Deluxe Stock Screener installed (Free), you can click on the following links to get the list of stocks that currently pass the screens: Jim Slater Small Cap GARP, Cornerstone Growth |
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