What This Strategy Aims To Do
The goal of this model is to serve the understandable and widespread desire among equity investors for growth, and to do so in a way that is not limited to a naive consideration of growth rates achieved in the past, which often do not recur in the future.
Why It’s Worth Considering
Growth is popular as an investment goal and that’s quite understandable. Unless investors have credible reasons to expect growth, there is no reason for them to divert capital away from fixed-income securities which carry much lower risk and often much higher yields.
Unfortunately, however, growth is the goal that is most likely to run smack against the well known and very accurate notion that past results do not assure future outcomes. In fact, when it comes to growth, if we want to take the simplistic naive view, it would probably be more accurate to suggest that high rates of growth in the past probably mean slower growth in the future. That’s based on the natural life cycle of a business, where it has the potential to grow very quickly in its earliest days but the bigger it gets, the harder it becomes to maintain the high rates of growth achieved early on. Even when historic growth is cyclical rather than secular (that is, growth is high because the company is recovering from a depressed period), we assume deceleration as profits approach more normal levels.
But growth is too important to equities to simply give up on. Besides, even if it can be argued that we should throw our hands up here, many won’t and will one way or another chase shares of what are perceived to be growth companies. (That’s why you see growth funds available in the marketplace, even though academicians typically do not consider growth to be a bona fide factor.)
This model therefore fills an important need, albeit one that is very difficult to fill. It aims to satisfy the appetite for growth and do so with stocks for which there are objective clues suggesting a reasonable probability of good growth in the future (if not at levels achieved in the past). In addition, we look to mitigate the valuation peril typically faced by growth investors: often, when a company really is a growth opportunity, enthusiasm among investors tends to drive valuations to levels that would be excessive even if favorable growth expectations are achieved.
How We Do It
We start with a fairly broad universe in terms of market capitalization; one that is not limited to large capitalization issues. We do this in deference to the above-mentioned business life cycle: While big companies can and do still grow, sometimes at very attractive rates, if we were to limit ourselves to this group, we’d probably miss too many other potentially worthy opportunities. (Note: We consider the top 35% in terms of market cap, but don’t overparse this. A very sizable portion of the entire equity universe is far too small to be prudently traded comfortably in an advisory context so reaching down as far as the top 35% allows for legitimate investable small-cap exposure).
Then we eliminate stocks from this group that have the potential to trade at troublesome valuations. We do this by either requiring a score of 90 or better in a multi-factor value ranking system or else that the stock’s Enterprise Value-to-Sales ratio be in the cheapest half of the group. The leeway we tolerate in terms of EV-to-Sales takes into account the reality that for many legitimate growth companies, earnings, cash flows, etc. have not yet reached their potential, thereby leaving sales-based valuation as the only metric that can be effectively considered. Too much lenience in this area can, as many have seen, get investors into trouble, but other aspects of our model guard against that.
Now we turn to growth itself. Since investments make or break based on what happens in the future, we limit consideration to shares of companies that rank highly in at least one of several tests we use to measure and compare analyst projections of long-term EPS growth.
If we could be sure analysts are always right we could stop here. But we can’t be, so we don’t. We need to support favorable growth expectations with here-and-now indications of capacity to grow. For that, we turn to measures of company return on utilized capital like return on equity. This is an important and often-overlooked indicator in this regard (see White Paper #1 for a detailed explanation). We also require that companies be not necessarily the least volatile in the investment universe, but at least in a generally more stable portion thereof (for example, within the most stable 40% in terms of Beta measured over a five-year period). This is important, because more stable companies tend to make for easier forecast burdens for analysts, thus lending an air of credibility to the long-term EPS growth forecasts on which we rely.
At this point, with these filters in place to pre-qualify our list of potential candidates, we’re ready to turn to our Growth-based ranking system, one we would likely hesitate to use on its own because of our inability to automatically connect past performance to future outcomes. We need to refine probabilities before we can use a ranking system like this. Ultimately, we’re going to sort and select the 20 stocks that rank highest with this metric.
But before we get to the sort, there is just one more safety valve. We need to address the well-observed likelihood that the most extreme growth rates are the ones that are least likely to persist going forward, typically because the numbers reflect either a young company moving through the early but not everlasting high-growth portion of its lifecycle or because numeric comparisons are being distorted by temporary factors that inflate recent numbers or depressed historical base figures. So before we use the growth ranking system to pick our top 20, we eliminate the top 5% of firms with the highest growth histories in the universe.
Before you scrutinize any companies that have made it into the portfolio, there is something important to understand about growth strategies: When it comes to good growth, you will rarely see a company with all of its oars in the water at the same time.
Through the processing of this model, many growth rates are considered, various measures and various time periods. The design of the model is such that the overall constellation of growth-based data items is favorable. But there are always likely to be individual comparisons for which one growth computation or another is lackluster or even negative. The model does not give special preference to the kinds of numeric comparisons likely to be most visible by casual observation. So do not be shocked, and do not presume the model has a bug, if you see look at one or more items and see poor growth comparisons. We could create a model that will show you only comparisons that look good. But investment performance would likely be diminished by excessive valuations and/or a lack sustainability of growth.
Our update-sell protocol reflects a combination of patience and stringency. We refresh the model once every three months. That, by standards of this kind of data-driven investing, is a generous time frame. (Actually, it’s as long a horizon as any equity strategy should have, given that fundamental data is updated quarterly; to us, a five-year holding period is really a three month-holding period in which the investor got the same answer on 20 consecutive updates.) Growth stories can unfold through fits and starts, so we’re willing to allow some near-term hiccups to occur without selling the stock. When the refresh comes, however, we force each stock to go back to the starting line and prove its worth all over again. If it meets the eligibility requirements for a new purchase, it’s held. If not, it’s sold.
Is It Suitable For You?
This is an equity model suitable for the mainstream investor, but one that requires a tolerance for risk that is a bit above average in this context. That is due to the inherent difficulties of building any model that must tackle the past-performance-future-outcomes conundrum. This alone would prevent us from pegging the risk of any growth models at or below the equity average. But assuming you are willing to take the risks that inevitably come from being a growth investor, this model should be suitable for you.
Investing In This Model
This model has high turnover. This is not unusual in rule-based models that depend on data to keep positions aligned with strategy. Due to the turnover, commissions could play a major factor in the returns.
It is also preferable to follow this model in a tax-deferred account to avoid paying short-term capital gains taxes. However, due to the turnover and relatively high number of positions, contributing a small amount each month can be very inefficient depending on your broker.