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Monday, July 10th, 2006

Scholars on Growth

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While some people reject academic research as lacking real world relevance, a review of literature reveals that the successful styles of growth investing, including momentum/aggressive growth and growth-at-a-reasonable-price (GARP), have solid academic underpinnings. This is a brief review of what academic researchers have found about growth investing and what it means for investors:

VALUE HAS HISTORICALLY OUTPERFORMED GROWTH IN THE LONG TERM

The authors of Triumph of the Optimists: 101 Years of Global Investment Returns, Elroy Dimson, Paul Marsh and Mike Staunton, of the London Business School, found that between 1900 and 2000, value stocks around the world outperformed growth stocks. Research specific to the UK found that this was also the case.

BUT THAT’S BECAUSE VALUE IS RISKIER

It’s constantly drummed into us that growth stocks are risky. But according to Eugene Fama, academic and father of the efficient market hypothesis, data shows that value stocks are riskier than growth stocks, as he outlines in this interview. Because of that, value investors get a higher return to compensate for the additional risk.

BUT WHAT ABOUT CHEAP GROWTH STOCKS?

I asked ‘Triumph’ author Elroy Dimson about challenges to his finding that value outperforms growth. He says most growth managers disagree with academics’ definition of value and growth. Most studies define value as low price-to-book value and growth as high price-to-book value. But most growth managers maintain “they’re buying stocks that have good prospects with long term growth without paying a premium that is excessive,” he said.

MOMENTUM STOCKS OUTPERFORM

Momentum investing has a reputation as risky and volatile. But the momentum effect in stocks is one widely recognized among academics as valid. That is, stocks that have done well, continue to do well. This has been documented in a number of studies, including a seminal piece by Narasimhan Jegadeesh and Sheridan Titman, which is highlighted in this paper.

THE MOMENTUM EFFECT ISN’T JUST SEEN IN THE US

As shown by a paper on European momentum investing, John Doukas and Phillip McKnight of New York University.

BUT MOMENTUM WORKS BEST WITH MOMENTUM IN PROFITS

Kent Daniel and Sheridan Titman found that momentum profits are significantly higher when the strategy is implemented on growth (low book-to-market) stocks rather than value (high book-to-market) stocks.

Narasimhan Jegadeesh also says here that “stocks with high earnings momentum outperform stocks with low earnings momentum.”

AND WITH STOCKS HITTING NEW HIGHS

Some research suggests that stocks hitting 52-week highs can explain most of the momentum effect.

BUT HIGH EARNINGS OUTLOOKS DON’T LEAD TO OUTPERFORMANCE – IT’S ABOUT SURPRISES AND EARNINGS ACCELERATION

Growth manager AllianceBernstein in a study found that high forecast earnings growth doesn’t produce superior returns, but earnings surprises do. The best way to screen for stocks that may create earnings surprises is to finds one ones with accelerating earnings

WHAT THIS MEANS FOR GROWTH INVESTORS:

Based on academic literature, successful growth investing methods are likely to be found in either medium-term momentum/aggressive growth style, or GARP-type strategies that seek to buy growth stocks at cheap prices to secure the value premium.

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Word Count: 486. This entry was posted on Monday, July 10th, 2006 at 7:34 pm and is filed under Books, Growth investing. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.