FTSE Russell Insights

Are investors defining growth stocks wrongly?

Ross French

Equity Index Research

The value–growth dichotomy of investment styles is well known, well reported, and has a long history in investment literature. The key theme of this literature is that, over the long-term, stocks with low price multiples, termed ‘value’, outperform those with high price multiples, termed ‘growth’. The data on this subject leaves no room for debate, and a wealth of research has demonstrated the existence of a ‘value premium’ across regions, time periods and even asset classes. Notwithstanding, one can debate whether the designation of high price multiple stocks as ‘growth’ is really fair, and our recent paper ‘Redefining growth: Using analyst forecasts to transcend the value-growth dichotomy’, published in two parts in the Journal of Beta Investment Strategies, does exactly that.

Motivated by our scepticism that price multiples are the best way of defining growth stocks, the first part of our paper analyses the ability of 17 potential predictors of growth to forecast future earnings growth rates. The conclusions from this exercise are clear - analyst earnings forecasts have historically been a more accurate predictor of future earnings growth than price multiples, profitability or historic earnings growth rates, and can thus provide an alternative definition of growth, liberating it from its anti-value association.

With our alternative definition in hand, we then test whether growth stocks really do underperform. The results from this exercise, presented in the second part of our paper, are intriguing and challenge the common perception of growth stocks’ historic performance. More specifically, we demonstrate that growth stocks, defined using analyst forecasts, have consistently outperformed market cap-weighted benchmarks across all regions analysed, and that this outperformance is not attributable to the existing style factors. The research then analyses two corollaries of this conclusion, finding that that 1) the explanation of the cross section of stock returns is aided by the addition of a growth variable and 2) multifactor strategies that combine growth with the established style factors outperform those that exclude growth.

The key implication of our research is that treating growth as a factor in its own right, rather than simply the opposite end of the value spectrum, can be beneficial for smart-beta investors, risk modellers or anyone with an interest in factor investment.

Read the full paper Factor Investing: Redefining growth using analyst forecasts.

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