By Jack Forehand, CFA (@practicalquant)
Growth stocks have been trouncing value stocks for a long time now. The chart below illustrates just how massive that outperformance has been. The Russell 1000 Growth ETF is up 114.85% in the past five years vs. just 22.99% for the Russell 1000 Value ETF. The same phenomenon has also occurred in the small-cap space, with the Russell 2000 Growth ETF handily beating the Russell 2000 Value ETF (although the margin is not nearly as wide)
The length and magnitude of growth’s outperformance has led to significant debate among investors as to whether we are in a new world where growth will dominate long-term, or whether mean reversion will occur and value will reassert its long-term dominance. Although readers of my articles already know I tend to lead toward the second camp, I don’t want to use this article to revisit that debate.
What I do want to do is talk about some of the most important things historical data shows and what I believe it takes to be a successful growth investor. Even though the rising tide of growth has lifted all boats in recent years, history shows us that likely won’t always be the case, and it is unlikely that this magnitude of outperformance will sustain itself long-term.
In studying growth strategies that work over the long-term, here are a few key things that stand out.
Growth Investing is About Finding Diamonds in the Rough
Although it is hard to believe it right now, value investors have typically had a significant tailwind behind them. The reason is that value stocks in general have generated an excess return over the market over the long-term. Value investors are able to start with that tailwind when building their portfolios and then apply their own stock selection techniques to hopefully build upon it and generate greater excess returns than a simple value approach. Some have succeeded and some have not, but either way, starting with a universe that outperforms has certainly helped.
Growth investors in general face the opposite problem. Portfolios based on simple growth metrics typically generate negative excess returns over time. You have to be careful when looking at academic research into growth because academics typically use expensive valuations as a proxy for growth, which obviously isn’t the optimal way to build a portfolio, but even if you use things like earnings and sales growth rates, it is still true that baskets of growth stocks trail the market over the long-term. The reason for this comes down to expectations. Growth companies typically trade at premium prices, and embedded in those premium prices are high expectations. Eventually, the typical growth stock is unable to meet those elevated expectations and its stocks pays the price for that.
Even though data shows that growth in general tends to underperform the market, it is also true that the best performing individual stocks typically come from the growth group. Great growth companies typically start out expensive and stay that way. If you look at some of the best performers from the current crop of great growth companies like Amazon and Netflix, there is really no point in their history where they were cheap by traditional metrics. But unlike growth stocks in general, they have consistently exceeded their high expectations, and thus have produced massive returns for their investors.
So that becomes the crux of growth investing. To be a good growth investor, you have to be able to find the small subset of stocks that will exceed expectations from a group where most will not. That is very difficult to do. I have personally always felt that this is one task a person is more suited to perform than a computer since it requires a deep dive into a company. But we have found a few strategies such as the one developed by Partha Mohanram that have had success doing this quantitatively.
The Best Growth Stocks Are Very Hard to Hold
There are a lot of misleading charts that get shared on Twitter. But I think one of the most misleading is the one where someone identifies a great growth stock after that fact and then tells you how much money you would have made if you invested in it from the beginning of its run. For example, here is what $10,000 invested in Amazon in 1997 would be worth today calculated using Portfolio Visualizer.
S&P 500 vs. Amazon – Could you Hang On?
|Portfolio||Initial Investment||Final Balance||CAGR||St. Dev.||Best Year||Worst Year||Max Drawdown|
If I had invested $10,000 in Amazon when it went public, I would be sitting on a beach somewhere instead of writing this article because I would have $6.8 million. This compares to just over $54,000 if I invested in the S&P 500.
That statistic is completely misleading, though, for two reasons: (1) It was impossible to know Amazon would have been the success it is with the information that was available at that time, and (2) There is almost no way an investor would have been able to hold it through the wild ride it took to get there.
For investors who invest in individual stocks, staying the course through major drawdowns is very difficult. And in the case of a stock like Amazon, we aren’t talking about 2008 S&P 500 like drawdowns of 50%. Those happened a lot in Amazon’s history. We are talking about a maximum drawdown of 93%. Could you have continued to hold it through that? I certainly could not have.
The second problem with investing in individual growth stocks is the opposite of the first. Once you have major gains, it is really hard not to lock them in. And with the best growth companies, you need to continue to hold through gains that far exceed even your wildest expectations. When I double my money in a stock, I am likely looking to sell it. By the time it is up 4x, there is pretty much a 100% chance I am out the door. Realizing the returns Amazon has generated has required continuing to hold while making 680 times your money.
But that is just the start of the challenge. Although each of those things are difficult to do on their own, they are nearly impossible to do together. For example, this hypothetical investor who held Amazon since its IPO would have had to endure 50% drawdowns after they had already made 10 times their money. They would have had to endure significant drawdowns after they had made 100 times their money. If you were sitting on those kinds of gains and saw them start to evaporate like that, could you have stayed the course? I give all the credit in the world to investors who have been able to do that, but the vast majority of investors could not.
The Challenges of Growth Investing
The great performance of growth in the past decade has led many investors to increase their allocation to the area. Whether that will end up being a good decision is a topic for a different article in the future, but for investors who do that, it is important to understand the reality of growth investing. That reality is that growth investing is hard and requires finding a small group of companies that outperform the market inside a group that typically does not. That reality is also that you will need to overcome your emotions on both sides of the equation by holding positions through significant drawdowns and through periods of significant gains. That is probably more than most investors will be able to do.
But the good news is that index investing, even though it certainly can’t match the returns of a strategy that can identify the best growth stocks in advance, does guarantee that you will hold them and see some of the benefits of their gains. For most investors, that may be the best way to capitalize on the returns of the great growth stocks.
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.