- Traditional growth indices, designed as the inverse of value, have delivered negative excess returns and failed to provide faster growth in earnings per share (EPS). Active growth managers, who track growth indices, have likewise underperformed the market.
- Companies that invest aggressively to grow assets and sales despite a low return on capital perform poorly, attributable to negative relative growth in EPS. Companies with a high return on capital and more disciplined growth strongly outperform, attributable to high relative growth in EPS.
- A smart beta growth strategy, by investing in profitable companies with conservative investment practices, can diversify value strategies while delivering a strong positive excess return from sustainably faster growth in EPS.
Investors have long used the “style box” to diversify their equity portfolios by allocating to a mix of growth and value funds. As intended, diversifying by style has reduced tracking error. Unfortunately, it hasn’t delivered the hoped-for outperformance. While value funds have outperformed the market, growth funds have underperformed.1
Value indices are built on strong theoretical foundations and have provided a long history of positive excess returns. Traditional growth indices, constructed as the inverse of value, lack a robust theoretical foundation and have provided a long history of negative excess returns. Even worse for growth investors, active growth managers have delivered underperformance along with high fees.2
Can investors find a simple systematic growth strategy to diversify their value funds that also provides a positive excess return? Yes! We show in this article that a smart beta growth strategy—investing in companies with sustainably high earnings-per-share (EPS) growth, as identified by high profitability and conservative investment—can diversify value indices, while also delivering a positive excess return.
The Failure of Growth Funds
In 1993, Fama and French synthesized previous academic work on the sources of equity returns to create the famous three-factor model: market, value, and size. Soon thereafter, “growth” came to be interpreted as the inverse of value. The logical assumption was that investors, in an efficient market, will set higher stock prices relative to book value in recognition of stronger future growth in EPS.
Following this interpretation, growth indices were created as the inverse of value indices; they were simply indices of expensively priced stocks. We now know, however, that more expensive stocks persistently underperform cheaper stocks. Unsurprisingly, traditional growth indices, inspired by this definition of growth, have duly underperformed.
Active managers endeavor to identify unrecognized or underappreciated companies likely to deliver future growth in EPS that more than compensates for any price premium. Unfortunately for the investors in these funds, active growth managers, much like growth indices, have generally failed to deliver positive excess returns. Active growth managers, on average, underperformed the market by nearly 60 basis points a year from January 1991 to June 2013—and this is before fees! 3
Smart beta seeks to deliver well-researched, systematic sources of excess return through transparent, low-cost investment vehicles. Informed by the Fama–French (2015) five-factor model, we explain how to create a smart beta growth strategy by combining the two new factors—profitability and investment—Fama and French recently added to their three-factor model.
Today, profitability and investment are well-known factors. The excess returns associated with these factors have been thoroughly documented in earlier papers.4 In this article, we demonstrate that the fundamental source of the excess returns delivered by profitability and conservative investment can be attributed to sustainably faster growth in EPS, the very attribute that growth funds attempt to provide. From this finding, we show these two new factors can be combined to construct a smart beta strategy that delivers persistent outperformance through high growth in EPS.
Smart vs. Dumb Growth Stocks
To illustrate the intuition supporting the empirical evidence, we explore several examples of smart and dumb growth stocks. The stock of a company with a low return on capital and a management investing rapidly to increase its scale of operations is a dumb growth stock. In contrast, the stock of a company with a high return on capital with a management that demonstrates discipline and skill in capital allocation is a smart growth stock. Our examples look at three points in time: the height of the dot-com bubble (July 1999), the eve of the global financial crisis (July 2007), and more recently, July 2016.
Let’s begin with the dumb growth stocks.
We examine three dot-com stars—Compaq, Yahoo, and WorldCom—which, like many companies in the late 1990s, were aggressively investing for growth in the new internet-connected economy.
Compaq was the largest manufacturer of personal computers in the 1990s.5 To build scale, Compaq, despite (or because of) falling profits, invested heavily in a series of aggressive acquisitions.6 These acquisitions failed to produce the hoped-for economies of scale, while the rapid expansion caused quality control problems. We were not able, for example, to write this article on a Compaq machine, because the company was acquired at a fraction of its peak price by Hewlett-Packard in 2002.7
Yahoo, in the late 1990s, was expected by the stock market to attain a leading (if not the dominant) place in the exciting new field of web search. Despite little apparent profitability at the time, Yahoo invested aggressively to capture “eyeballs” and traffic. Although web search did become extremely valuable, Yahoo did not. Simply put, Google came along and did search much better.
WorldCom was the second-largest long-distance communication provider in 1999, a position achieved through aggressive acquisitions of technologies and networks. WorldCom financed its (loss-making) growth using rapid stock issuance, large amounts of debt, and some accounting fraud. When investors discovered that the industry had massively overinvested in fiber optic communication infrastructure, the game was up. WorldCom filed for Chapter 11 protection in 2002.
Financials, in the lead-up to the global financial crisis of 2008, are another example of dumb growth. Politicians, the media, and too many investors viewed securitization of mortgage debt as modern financial alchemy. Many of the banks that were among the most aggressive in stuffing their balance sheets with mortgage-backed securities have since failed or been acquired at fire-sale prices, leaving investors high and dry.
Now, let’s look at a few examples of smart growth stocks, in particular, Coca-Cola, Exxon, and Kellogg’s.
Over the three periods we examine, these companies have consistently ranked at the top of large companies sorted by high profitability and conservative investment. Each has cultivated its competitive advantage to dig a moat around its profitability. The managements of these companies have been careful stewards of their investors’ capital. All three slowly and steadily grew to global dominance in their industry.
Yes, of course, we cherry-picked these examples. Nonetheless, these vivid descriptions of dumb-versus-smart growth stocks illustrate empirical facts: companies with high investment, despite low profitability, fail to provide strong returns to shareholders, and in contrast, companies with high profitability, paired with low investment, deliver sustainably high returns.
More recently, Tesla, Facebook, and Netflix are examples of companies with an aggressive level of investment combined with a low return on capital. Are these companies poised to be the next Apple and Google, or will they go the way of Compaq, Lehman, and WorldCom? We have no specific information about the future prospects of these high-flying market darlings, but history teaches that, on average, companies with a low return on capital, paired with aggressive investment, have provided poor returns to investors.8