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Dreams vs. Reality: Are growth investors engaging in wishful thinking?

Updated: May 14



At Left Coast, we heavily tilt our buy and hold stock investments toward value stocks while avoiding growth stocks. Value and growth investing are polar opposite styles, and we believe that value investing offers a more reliable and practical approach to achieving success in the stock market for our clients.


In the 1930s, Benjamin Graham, the father of value investing, intuited that investors often exaggerate good news and bad news, leading to deviations in stock prices from their intrinsic value. He believed underpriced value stocks, which were often unpopular among investors, would do better in the long-term as prices eventually revert upward toward intrinsic value. In contrast, highly priced growth stocks would underperform as prices revert downward toward intrinsic value.



Growth stocks must grow for investors to not lose


The term "growth" can be misleading to new investors. It may sound like growth stocks will make your portfolio grow, but that's not so. Growth companies must grow their earnings for investors to earn a reasonable return.


A simple example uses the popular Price / Earnings ratio. If you paid 20x the annual net income of a car wash to buy it, it would take 20 years to recoup your investment if earnings stayed flat. If you knew that earnings would grow, you might be willing to pay more for the car wash, especially if you were competing with other buyers. If you paid 100x earnings for a company you either expect it to grow, live for a long time, or don't care to earn much for your investments. High P/E companies are the growth companies.


Investors have only so much patience and live for only so long. Companies that have a high enough P/E ratio must grow their earnings to make the price you pay today worth the wait. Near its peak in 2020, Tesla's P/E was over 1100x earnings according to Macrotrends. Even Methuselah wouldn't pay so much for a company unless there was an expectation that its earnings would grow enough to make it worthwhile.


Let's assume that a P/E multiple of 20x is reasonable for a long-term investment like stocks. To achieve a return in line with a 20x multiple, the 100x business needs to increase its earnings by 5x; about 17.5% growth every year for the next ten years. Meanwhile, the price of this stock is staying flat and not paying its owners a dime. Should the company falter, the price could drop like a stone.


The company would need to surprise the market with even higher growth for investors to receive a return.



Good luck reaching high growth for any number of years


In their 2002 study, The Level and Persistence of Growth Rates, Chan et al. set out to discover if companies can reliably achieve high rates of growth and whether it's possible to predict company growth.


They investigated several metrics and found no reliable predictor of earnings growth. Professional stock analysts could differentiate high-growing companies from low growing companies but only in the short term. Companies with high P/E multiples did not reliably grow faster than companies with low multiples.


Chat et al. found that only about 10% of all companies have been able to achieve the annualized growth of 18% over ten years that's needed for investors to not lose money in our example. Would a company with earlier spectacular growth (and commensurately high prices) be able to continue their streak into the future?


They found that top line sales (how much you collect from customers) growth showed significant persistence, but it did not carry to the bottom line (how much you keep after expenses), where it matters for investors. By throwing money at aggressive expansions or deep discounts, companies can easily generate unprofitable sales that don't serve their investors.


Even technology companies were found to have a hard time sustaining growth despite their industry growing, thanks to new competitors taking market share.


The chart below shows how many companies can sustain greater than median growth for up to five years in a row. The black line shows what you would expect if results were dictated by a coin toss. Blue lines are companies whose earnings were in the top half or quartile for each of the last five years. Orange lines are the companies whose earnings were in the bottom half or quartile for each of the last five years.


Source: Chan et al. (2002)

Simply put, companies can't reliably sustain the growth implied by our 100x P/E car wash example, let alone a much lower bar. If anything, it shows that companies with the weakest growth (potentially value companies) do better the following year than any other group until they, too, join the crowd.


Paying for growth makes sense if that growth is attainable, but the data show that realized growth doesn't justify the prices of growth stocks.


Now that you know that real growth is fleeting, would you still make long-term investments in stocks with wishful thinking priced in?

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