You might be invested in “dumb” growth.
According to a recent report from Newport Beach, Calif.-based Research Affiliates, traditional growth indexes often produce negative excess returns and fail to provide faster growth. Active growth managers also tend to underperform the market.
“Those who believe the markets are efficient assume that growth stocks are trading at high multiples because they will have faster future earnings growth, or that they’re less risky than value stocks,” says Chris Brightman, CIO of Research Affiliates. “We’ve found that growth stocks are, in reality, just overpriced stocks.”
A traditional growth index, explains Brightman, has been designed as the inverse of a value index. Style indexing and style-box investing has led to growth and value indexes that respectively represent the most expensive and least expensive parts of the market.
While investors have associated relatively cheap value stocks with excess returns since the days of Benjamin Graham, there is no such return premium associated with expensive stocks, notes Brightman.
“The average value manager outperforms before fees,” he says. “Unfortunately, because of performance chasing, the average investor in value funds still underperforms the market. The underperformance is even larger after fees. The average growth manager underperforms before fees, underperforms even more after fees, and because of performance chasing, the average investor in growth funds performs worst of all.”
Growth-oriented managers and stock pickers tend to track the indexes, says Brightman, which explains their underperformance.
When investors say “growth,” they usually mean growth in earnings per share (EPS) as a portion of total return, says Brightman. Active or indexed, traditional growth provides lower dividend yield, negative valuation changes and negative earnings growth. Indeed, between January 1968 and March 2017, a traditional growth index posted a negative real return from dividends, -0.7 percent, valuation, -0.06 percent, and EPS, -0.06 percent.
“We ask whether we’ve learned anything since these first indices were created that could simplify a portfolio and transparently and systematically position it to have future growth in EPS that is materially higher than the market. If that’s possible, then can we actually do it in a way that produces higher returns.”
Eugene Fama and Kenneth French found that profitability and investment impact equity returns. The study by Research Associates finds that those factors also affect earnings growth. While higher profitability delivers higher growth in earnings, it may also lead to negative excess returns from low dividend yields and depreciation of valuations. The paper uses return on equity as a measure of profitability.