One of the most dangerous and consequently costly illusions in investing is the great company = great stock investment fallacy. We were reminded of this point recently when we witnessed the market’s reaction to a certain well known, but not-to-be-named company’s second quarter earnings announcement and accompanying management conference call.
In its announcement, the company revealed that during the second quarter it grew its revenue by more than 10% from the prior quarter and more than 40% from the same quarter a year earlier. The company further stated that it projected its revenue to continue to grow at a 30% year-over-year pace in the quarters ahead. What’s more is that the company translated its impressive revenue growth into profits as the company also shared that its operating income grew nearly 8% on a quarter-over-quarter basis and more than 30% from last year’s level. In other words, the company wasn’t just generating empty money-losing revenue growth with hopes of future profitability, it was profitable and growing in the here and now!
What happened to this company’s stock price the next day (the earnings were announced in the late afternoon following the close of trading for the day)?
Answer: The stock was pummeled and declined by nearly 20%.
A natural question to ask upon learning this is: how the heck did that happen?
The short answer is that the market had collectively been expecting even more growth from the company and when those expectations weren’t met, investors responded swiftly and ruthlessly by selling and driving the price of the company’s shares down to a level commensurate with the market’s now lowered growth expectations.
This episode serves as a salient example illustrating the tyranny of high expectations placed on glamour or growth stocks. A glamour stock is one with strong growth (revenue and profits) that is selling at a high—oftentimes, very high—multiple to fundamentals such as earnings (e.g., it carries a high price-to-earnings ratio). Whereas a typical or average stock usually trades at a multiple of roughly 20 times earnings, glamour stocks can trade at 35 (in the case of this particular one prior to its 20% drop), 70, 100 or more times earnings—as some other current high fliers do today—depending on the market’s expectation for a given company’s future growth.
This problem for many glamour stock investors is that very few companies are able to live up to such lofty growth expectations. Two landmark studies have separately examined the future growth rates of glamour stocks and concluded that while glamour stocks on average do tend to grow faster than a typical stock in the years ahead, their growth rates are not nearly sufficient to warrant the elevated valuations placed on them.
Value investing—the counterpart to glamour investing—does not suffer from this problem. In fact, it seeks to capitalize on it. The value investing philosophy—generally credited to Warren Buffett’s mentor, Benjamin Graham—is predicated on buying securities at prices that are low relative to their fundamentals (e.g., stocks that trade a low P/E ratios). Countless empirical studies of past market performance have demonstrated that value investing has delivered superior returns than growth investing on average over long investment horizons. Why has this been the case?
Researchers are generally split into two camps. One camp argues that the superior returns associated with value investing are simply compensation for the increased riskiness of value stocks. The other camp—and the more relevant one to this commentary—argues that value’s historical performance advantage is a result of investors suffering from decision-making errors that result in them naively extrapolating companies’ recently realized growth rates too far into the future.
This camp posits that investors tend to see the high past growth rates of growth stocks and the low past growth rates of value stocks and extrapolate both into the future. In doing so, investors push the share prices of growth and value stocks in opposite directions—up and down, respectively. This is why growth stocks are expensive and value stocks are cheap. When future growth tends to fall short of the overly optimistic forecasts embedded in growth stocks’ prices, they tend to fall and underperform. When future growth tends to exceed the overly pessimistic expectations embedded in the prices of value stocks, their prices tend to rise and value stocks outperform. Ultimately, value’s outperformance isn’t the result of the value companies delivering world-beating growth and profitability in the years ahead, it’s simply because their performance comes in better than the very low expectations held for them owing to investors tendency to extrapolate their poor recent performance too far into the future.
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 Bernstein in “The Four Pillars of Investing” summarizes a study from Fuller and others that examined the future growth rates of popular growth stocks—those in the top fifth of the market in terms of their P/E ratio—and found that these companies on average “increased their earnings about 10% faster than the market in year one, 3% faster in year two, 2% faster in years three and four, and about 1% faster in years five and six. After that, their growth was the same as the market…In other words, you can count on a growth stock increasing its earnings, on average, about 20% more than the market over six years. After that, nothing.” Grey, Vogel, and Foulke in “DIY Financial Advisor” cite a separate study by Dechow and Sloan that found that future 5-year earnings growth rates are similar across cheap (value) and expensive (growth) stocks.