More on the value of growth
In an earlier post here, we highlighted the importance of earnings growth to company valuation. The unsurprising conclusion was that a business that is able to maintain steady growth over an extended period of time can accumulate tremendous value.
Today we look at it from another, more quantitative angle, and ask how useful historical growth rates are as an indicator of future investment merit.
We start by analysing the relationship between historical EPS growth rates, and future investment returns, using evidence from the last ten years in a range of global markets, to find out whether high growth is the key to investment success.
In summary, the answer appears to be a clear “Nup.” In most developed markets, our numbers suggest no relationship, or a negative relationship between historical EPS growth and future returns. In a small number of markets we do see a positive relationship, but even this disappears after we control for share price momentum.
What this means is that choosing investments on the basis of whether they have a good EPS growth track record is unlikely to be a very successful strategy, which may seem a little counter-intuitive. The analysis doesn’t tell us why this is the case, but we can suggest some hypotheses for why it may be so:
- Firstly, calculating historical EPS growth rates is kind of easy. Any investor can do this this, and most of them do, so we shouldn’t expect that this calculation offers any unique insight.
- It follows that companies with higher EPS growth should trade at generally higher prices than lower growth companies, and experience tells us is what happens. If the market has already factored into the share price the benefit of high growth, then the potential for excess return has already gone.
- Then there are human biases potentially playing a role. When an analyst estimates future growth rates for a company, a powerful anchoring effect arises, and it can be hard to resist the temptation to extrapolate the recent growth rate some way into the future. A quick look at broker consensus earnings forecasts compared with historicals will show you this approach is pervasive. However, in many cases, the future will turn out differently to the past. For example mean reversion will affect many companies, with high growth companies having greater potential to disappoint, and low growth companies more room to surprise on the upside.
This leads us to a view that, while growth rates are clearly fundamental to estimating the value of a business, it’s not good enough to simply examine what has already happened. You need to think more carefully about the future to gain insight that is not obvious to others. For example, are there short-term tailwinds or headwinds which may abate in years to come? Is the business approaching some natural growth limit or point of declining marginal returns? Has it been investing in capacity that will allow it to leap forward in the years ahead?
More generally, when you delve a little deeper into a company than others have gone, and gain genuine insight into what the future may hold, that’s the point at which you generate real investment alpha. It’s not necessarily an easy thing to do, but you probably knew that already.
Tim Kelley is Montgomery’s Head of Research and the Portfolio Manager of The Montgomery Fund. To learn more about our funds please click here.
Tim joined Montgomery in July 2012 and is a senior member of the investment team. Prior to this, Tim was an Executive Director in the corporate advisory division of Gresham Partners, where he worked for 17 years. Tim focuses on quant investing and market-neutral strategies.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
bex taiwan
:
Tim its depressing to hear that it means so much work for alpha :( This is something i’ve been grappling with over the past 6 months. I originally learned from a Buffett following fund manager that the qualitative aspect was essential and he would put in many hours / weeks into a qualitative assessment. However his historical returns have not been THAT brilliant – circa 16% / annum over the past 10-15years. Can I get your thoughts on another option – the Skaffold portfolios’ which are selecting 5 companies for 12 months based on forward EPS estimates. This is something I feel relates to Walter Schloss’s comments about Peter Lynch burning out after 13years for too much qualitative assessment. I also note that for the individual investor with smaller funds (as opposed to a fund like yourself) we don’t have as many resources (cash) / relationships (company, analyst) to get a good qualitative assessment. Every hour we put into qualitative assessment is an opportunity cost of both our work time and and leisure time, thus reducing our alpha. I guess also if with accept that future market moves are random, we don’t always know whether markets will agree with our qualitative view. Another aspect is an overconfidence bias – how easy it is for humans to build a qualitative picture of a firm that markets may not agree with but that we have convinced ourselves is right. As an experiment I built a Skaffold type portfolio (2/1/15) based on my own spreadsheet – 10 companies, cheap relative to an IV model, based on 12 month forward earnings. To click a few buttons and take the top 10 companies took all of 5 minutes. EAX come into the model which is down circa 50%; including this, the portfolio is still up around 15%, add onto this dividends and franking credits perhaps 17-18%. For 5 minutes work I think that’s a great return. Another view would be Joel Greenblatts “Joel Greenblatt: Magic Formula Investing – Forbes part 1 and part 2” on youtube. In this video Joel makes what I think are two interesting points – …. “if you looked at the list of companies and you read the papers you wouldn’t buy any of the stocks”. I.e. 2008. Most of the companies are not brilliant. There is a reason why people don’t want to buy these stocks. Yet despite this, they still have high ROC’s however for whatever reason, people don’t think their future is too bright”…. and ….’Greenblatt states he couldn’t pick the companies that would/wouldn’t outperform despite his previous success in equities. This suggests letting the formula work rather than human intervention.’. I see this as requiring an objective process based on some set of data and putting together a portfolio and accepting what Peter Lynch mentions, some companies will do great, some poor, these cancel out and you take the average. I know I’ve waffled here Tim, apologies, just something that’s been on my mind lately and would be interested in your take. Thankyou.
Tim Kelley
:
Hi Bex,
Skaffold is a separate business to us, and its hard for me to comment specifically on the approach you outline, but there are some general points worth making. Firstly, I am very sympathetic to the Greenblatt world view and am a fan of rule-based investing, which can take the emotional aspect out of investment decisions. Provided you have confidence in the rules applied, this can be a time and cost-effective way to go about selecting stocks. I would say however, that to properly test and get confidence in the rules requires a lot of data and a long time frame. Over short time periods and with small portfolios, there will be a lot of random noise in the results, and while it is only human to take heart from results over a 6 month period, this may not be very robust, statistically speaking.
For our part, we try to take advantage of quantitative tools to the extent we can, but we also believe we can add to the investment decision by doing our qualitative homework. Its not always an easy task, but we have a bright team which is happy to spend the working week trying to eke out some extra alpha, so it makes sense for us.
Patrick Poke
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“More generally, when you delve a little deeper into a company than others have gone, and gain genuine insight into what the future may hold, that’s the point at which you generate real investment alpha. It’s not necessarily an easy thing to do, but you probably knew that already.”
Indeed! If it was easy, everyone would do it, and there’d be no advantage to be gained anymore.