Whether you are a card-carrying value investor, a quant investor immersed knee-deep in empirical asset pricing, or an academic working in the same field, you tend to think of growth as an unpleasant 6-letter word. It just doesn’t come naturally.
Not long ago, we’d count ourselves in that camp. In our minds, successful growth investing was borderline alchemy. Sure, there might be a handful of true growth grandmasters who can pull it off. Figured out the alchemy that is. Unfortunately, far more growth gurus have fallen by the wayside than made it to the other side. Since we’re certainly no growth grandmasters, we placed growth investing in the “too hard” pile. What’s more, we viewed systematic investing, our bread and butter, as particularly ill-suited for the task of uncovering growth stocks.
However, sometimes old dogs learn new tricks. The catalyst? In this case it was a project with Atlas, our new portfolio customization service, that pushed us right down the rabbit hole. The goal of the project was to come up with an investment strategy that provides both balance and flexibility to a portfolio with significant embedded size and value exposures. As such, we needed something that worked well within large and mega caps and wasn’t related to value investing. It goes without saying but we needed to do it without abandoning our principle of grounding investment strategies on strong empirical evidence and economic logic. This was a tall order.
In this blog post, we’ll discuss our journey in and out of the rabbit hole. We dove in with some trepidation but eventually climbed out with a broader mindset, and more importantly, a valuable investment strategy in hand.
The Problem with Growth Investing
Why do so many investors consider growth investing such a bad idea? To answer that, let’s divide stocks into two groups: stocks with low P/E ratios and stocks with high P/E ratios. Most often, the former group is labeled value, while stocks in the latter are considered growth stocks
Ask any investor well-versed in quant investing and they’ll tell you that the two groups are far from equal. The data says, loud and clear, that value stocks have, on average, produced superior returns. The return difference between these two groups is the famous value premium.
Now, imagine a stock-picking fisherman who must decide which pond to fish in. In terms of who catches the most fish, the odds are stacked against the growth pond and in favor of the value pond. There’s more fish in the latter. That’s the same value premium again. But the tables turn if we ask who catches the biggest fish? Fish as big as big as Volkswagens, the highly coveted 10-baggers, are leisurely hiding away in the growth pond.
A look at the historical record shows that multi-bagger stocks tend to be growth rather than value. This is the allure of growth investing. Go big or go home. And if you’re a hall of fame angler, that makes sense. You go catch that giant catfish and ignore the little herring in the value pond. But the unfortunate fact about the growth pond is that for every juicy 10-bagger, there’s a swarm of lookalikes and imposters barely breaking even. They bite hard and fight back like hell but don’t give you much to show for.
Quant investing typically relies on harnessing phenomena (or factors, return drivers. You name it) that only spring to life in diversified portfolios where stock-specific effects are neatly washed out.
So, systematic investing tends to rely on wide diversification. But the more you diversify among growth stocks, the more your portfolio resembles the overall growth pond. This is not what you want, you’d be fighting the value premium. Catching the winners while maintaining a concentrated portfolio requires precision rarely attainable via systematic means. That’s why we felt there was a mismatch, a fundamental disparity almost, between growth and systematic investing.
The Value/Growth Dichotomy
An old joke about economists goes like this. A group of three end up shipwrecked on a deserted island. They have canned goods but no way to open it. After the other two fail to solve the problem, the economist finally comes up with the answer: “Assume we have a can opener…”.
While the above assumption is clearly ridiculous, other assumptions are much easier to mistake for the truth. In fact, our pond-analogy was based on a questionable assumption. We assumed, to the appall of real-life growth investors, that growth is the opposite of value. In our industry, the very definition of growth is usually taken to be the opposite of cheap.
But are value and growth, like yin and yang, truly opposites? The idea that they are, stems from academia. While no actual growth investor would accept expensive as the definition of growth, to place an equal sign between them is not as crazy as you might think. Why not? Well, the formidable body of research on value investing shows that cheap and expensive stocks are very different. A typical cheap stock has been dragged through the mud and rarely exhibits neither past nor future growth. Cheap stocks are more frightening than exciting. Expensive stocks, on the other hand, are not only glamourous and cool but fundamentally better. They have less debt, higher profitability and importantly, they’re poised for growth.
Higher valuations come, for the most part, from higher future growth expectations. The markets expect stocks with high valuations to grow much faster than cheap stocks. And grow they do. Just not enough to justify their price tags. Cheap stocks are the opposite. They don’t grow much yet still manage to beat the expectations placed on them because the bar has been set low. The value premium is rooted in this phenomenon.
So, we can, with a reasonably clean conscience, still call expensive stocks growth stocks. Herein lies the rub though: expensive is far from the only possible definition for growth. For instance, the past is a decent guide. Stocks that have been on an upward earnings trajectory tend to continue growing while laggards are likely to remain just that. Now, we knew from existing value literature that forming portfolios on past growth would lead to subpar returns.
A big turning point in our thinking came when we remembered the somewhat esoteric and surprising fact that momentum firms grow fast. The light bulb came on: momentum is a growth strategy in disguise! We reasoned that there are likely other strategies like that: strategies armed with solid long-term track records that favor growth companies. Put another way, there’s a way to do smart quantitative growth investing.
Armed with this realization, we turned to asset pricing literature.
The Anomaly Literature
Our plan of attack was to start pouring over the academic anomaly literature and to look for return drivers that resonate with growth on an intuitive level. This task is made complicated by the sheer amount of so-called return predictors identified in said research. In 2011, John Cochrane famously characterized it as a “zoo of factors”. Some eleven years later, the zoo animals have taken over the neighborhood and look to capture the whole city next.
Luckily, coping with the ever-expanding zoo is made easier by some excellent replication studies effectively summarizing much of the research. These herculean studies provided a good launchpad for our journey towards planet growth. What we found was that, besides momentum which is growth in incognito mode, there are several growth-like measures that make a compelling case for themselves. We shortlisted a small collection of return predictors that filled our initial criteria. They needed to pass the summary studies’ replication filter and hold promise of growth-like tendencies.
A list of candidates at hand, we measured the selected strategies’ correlations with the value factor. Some strategies we thought would be growth were surprisingly close to value. So, we cut those. Next, we applied the strategies only within large caps and compared the return to the market benchmark (as opposed to the short leg of the strategy). This procedure further narrowed down our list of potential growth metrics.
Finally, we examined the mechanics of the strategies. It’s well understood that mechanism behind systematic value strategies is mean reversion in valuation multiples. That is, valuation multiples tend to converge towards the mean. Expensive stocks are more profitable, grow faster and carry, by definition, a higher valuation multiple than cheap stocks. The value premium is positive when expensive stocks outgrow cheap stocks by less than the valuation multiples converge.
Our implementation of growth works the other way around. The strategy’s stocks have tended to outgrow their shrinking multiples (relative to the market). We think that’s a good bet to produce truly uncorrelated returns from value. At the end of the day, we settled on six measures that can be broadly categorized to either measure growth momentum or predict expected investment growth.
Conclusion
We believe value and growth can coexist. That’s what we learned down in the rabbit hole. Or perhaps it’s better to say that we unlearned that the opposite of value is automatically growth. Expensive stocks are growth stocks undoubtedly, but growth can be defined using other more investor-friendly metrics. Growth can be harnessed, captured, and turned into an effective investment strategy grounded on years of solid empirical research. So, it’s time to rename what we originally called the growth pond to the more suitable expensive pond. Don’t fish in that pond. But there is a real growth pond where you can succeed – you just have to find it first.
The portfolio came to life in form of the Evli USA Growth fund in September 2022.
