AAII emailed me about its new AAII Growth Investing service. I am not going to subscribe to it, but I have wondered about how you define a growth stock. Value stocks are typically defined as those with low P/B or P/E ratios, but growth investors are not looking for high P/B or P/E stocks, although they are willing to pay higher multiples for companies with the right attributes. Is there a growth stock ETF that people think is constructed well?
Below is a quote from AAII on their methodology:
STEP #1:
We utilize a growth approach based on groundbreaking academic research called the G-Score, an eight-point scale that scores companies based on:
Profitability and Cash Flows — How many growth stocks realize huge price runs despite losing money and having no clear path to profitability? And how many of those end well? When macroeconomic headwinds arise, profitability matters and is rewarded more than ever.
Business/Earnings Variability — By identifying companies with stable earnings and sales, AAII Growth Investing avoids firms that have “phantom earnings,” or earnings without cash generation, as well as companies that influence earnings through creative accounting methods.
Accounting/Spending Conservatism — By identifying companies that spend on activities that can help growth (like high research & development investment or more spending on marketing), we find more companies with the potential for longer-term profitability.
STEP #2:
Then, we pair the G-Score with an enhanced Growth Grade. Reversion to the mean frequently occurs in stocks with high growth, so we looked to create a new and improved grade that captures a company’s future growth potential through a “sweet spot” of growth — not too high and not too low — that will perform more consistently. The new Growth Grade is based on:
Year-Over-Year Sales Increases — We examine a company’s sales track record, but with an eye for consistency of annual increases.
Five-Year Average Annual Sales Growth — Stocks with the weakest sales growth and strongest sales growth (due to reversion to the mean) underperform stocks with positive yet slower and more sustainable levels of growth. This key component of our grade finds the “Goldilocks” balance of growth potential.
Five Years of Positive Cash From Operations — Positive (and increasing) cash flow from operating activities shows that a company’s core business activities are thriving and provides an additional measure of profitability potential of a company.
STEP #3:
Using both of these metrics to aid in our investment decision-making, we’ve created a model portfolio strategy with backtested performance that has beat the S&P 500 index by 91.2% over the last three years and eight months.
By definition a stock is either a value stock or a growth stock. They are mirror images.
I have not picked apart the above methodology but it feels active/quantitively. Nothing wrong with that, I am a mild propionate of active management.
But you have hit on something that people are not looking for high P/B ratios, etc. The industry is moving from the Value/Growth dimensions to a Value/Not-Value dimension. If you are going to group assets into a asset class then those assets should act alike. For example, grouping stocks into companies that start with A-O/P-Z does not make any sense. Objective criteria but it does not give you any actionable actions. Value stocks tend to act like other value stocks. i.e., high correlation within the group. On the other hand growth stocks don't act like other growth stocks. i.e., low correlation within the group. This is why we are drifting to the 5 factor model. size, value, momentum, quality, and low volatility.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
Personally, I think these quant screens (much like factors themselves) represent a view that's extremely naive to how much analysis and information goes into the valuing of any stock. The idea that a sector with a million pieces of information factored in can be more accurately elucidated with a single metric (that might take 1-6 pieces of information in) seems to me a trick of back-fitting. Especially as so much information concerning value and growth these days is non-quantitative (e.g. brand value, the value of data/intellectual property, the future value of an industry, etc.).
I think you do get non-growth stocks on higher valuations – e.g. utilities provide pretty solid earnings and dividends, and there's a premium for stability. I also think the 'Amazon model' of growth (as described in Zero to One) – where a business doesn't even try to make a profit, but rather builds a monopoly on investor capital, nonexistent margins and data – takes active management to define, because there isn't really a metric for it. A PE ratio of 7,000 might strongly suggest it; but I think if you want growth (implying higher than market returns) you'd want good active management, and maybe private equity/VC. The growth index underperforms.
1. Future Long-term Growth in Earnings Per Share (FLGE)
2. Future Short-term Growth in Earnings Per Share (FSGE)
3. Three-year Historical Growth in Earnings Per Share (HGE)
4. Three-year Historical Growth in Sales Per Share (HGS)
5. Current Investment-to-Assets Ratio (INV)
6. Return on Assets (ROA)
Logan Roy wrote: ↑Wed Nov 02, 2022 11:47 am
Personally, I think these quant screens (much like factors themselves) represent a view that's extremely naive to how much analysis and information goes into the valuing of any stock.
I have to think, though, if we're trying to aggregate 1000 stocks into a category, this is the right way to do it. The idea being that you may be grievously misled about some of the stocks, and clearly you are, but the benefit of picking 1000 stocks in 2 seconds is plenty high enough to pay you back for making that mistake. Naivety is valuable if it's used properly.
I suppose that stocks are always getting into the wrong category by virtue of unstable earnings, and then too, they're also getting into the wrong category by a sufficient level of investor delusion, if it's available. You can argue that there's not enough delusion available to misprice a stock, but I'm sure not going to. I wouldn't dare.
You can do a whole lot of analysis and still get surprised, too. The company says "hey this new product we talked about all year/decade, we just realized we can't make it" or "can't make it at a profit" or "we're going to destroy some shareholder value by ill-advised mergers and spinoffs."
Logan Roy wrote: ↑Wed Nov 02, 2022 11:47 am
Personally, I think these quant screens (much like factors themselves) represent a view that's extremely naive to how much analysis and information goes into the valuing of any stock.
I have to think, though, if we're trying to aggregate 1000 stocks into a category, this is the right way to do it. The idea being that you may be grievously misled about some of the stocks, and clearly you are, but the benefit of picking 1000 stocks in 2 seconds is plenty high enough to pay you back for making that mistake. Naivety is valuable if it's used properly.
I suppose that stocks are always getting into the wrong category by virtue of unstable earnings, and then too, they're also getting into the wrong category by a sufficient level of investor delusion, if it's available. You can argue that there's not enough delusion available to misprice a stock, but I'm sure not going to. I wouldn't dare.
You can do a whole lot of analysis and still get surprised, too. The company says "hey this new product we talked about all year/decade, we just realized we can't make it" or "can't make it at a profit" or "we're going to destroy some shareholder value by ill-advised mergers and spinoffs."
Yes. I think there are definitely arguments for that. So a value screen filters out a lot that might be speculatively priced. And there was a good argument about 18 months back: that if you put all the 'Cathie Wood' growth stocks together, and believed they'd grow into their valuations, you'd need a stock market about two or three times as large to fit them all in. So I think that may have been a sign of too much liquidity, and an interesting way to question valuations.
Rewind a year and a bit, and I did buy a value ETF, and it was a good decision. But I remember for a long time before that, a world of 1% rates and 'zombie' businesses made the prospect of value quite unappealing – as it was filtering out the Amazons and Teslas, and maybe have been overweighting the unsustainable. So I think it's something between precarious and skilful to actually use these things to improve portfolios. Do they pose more problems than they solve?
alex_686 wrote: ↑Wed Nov 02, 2022 10:04 am
By definition a stock is either a value stock or a growth stock. They are mirror images.
I have not picked apart the above methodology but it feels active/quantitively. Nothing wrong with that, I am a mild propionate of active management.
But you have hit on something that people are not looking for high P/B ratios, etc. The industry is moving from the Value/Growth dimensions to a Value/Not-Value dimension. If you are going to group assets into a asset class then those assets should act alike. For example, grouping stocks into companies that start with A-O/P-Z does not make any sense. Objective criteria but it does not give you any actionable actions. Value stocks tend to act like other value stocks. i.e., high correlation within the group. On the other hand growth stocks don't act like other growth stocks. i.e., low correlation within the group. This is why we are drifting to the 5 factor model. size, value, momentum, quality, and low volatility.
Are growth and value mutually exclusive? From how I understand it value stocks are companies who are undervalued, by whatever metric the index uses like PE. But growth aren't overvalued companies, they are companies that have strong earnings reports and low debt and consistently growing etc.
Now those due tend to go hand in hand, people will invest in the company that is doing well and drive up its price. And growth investors are fine with a higher price im a company with consistently good fundamentals. But that's not always the case.
Isn't it possible for a company to have the traits of a growth company (consistently rising profits, low debt, etc) but also undervalued with a PE rating thats low for whatever reason?
Trance wrote: ↑Thu Nov 03, 2022 12:49 am
Are growth and value mutually exclusive? From how I understand it value stocks are companies who are undervalued, by whatever metric the index uses like PE. But growth aren't overvalued companies, they are companies that have strong earnings reports and low debt and consistently growing etc.
Now those due tend to go hand in hand, people will invest in the company that is doing well and drive up its price. And growth investors are fine with a higher price im a company with consistently good fundamentals. But that's not always the case.
Isn't it possible for a company to have the traits of a growth company (consistently rising profits, low debt, etc) but also undervalued with a PE rating thats low for whatever reason?
From a fuzzy marketing viewpoint they are not.
From a formal academic viewpoint they are mutual exclusive.
To extend, Value/Growth does not mean over/undervalued. Or to put it another way, value stocks are not a good value, rather they are cheap because they then shoddy. I am overstating my case but there is a reason why value stocks are cheap.
Yes, in theory one could have a company that has a low P/E ratio and high expected growth. You can also find people who are significantly above average in height and significantly below in weight. These are rare. Not just there is a correlation but casual affects. Companies that have both of these characters are facing unique situations. As such it would not be wise to group them together because they are not going to act similar.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
-Have consistently beat the market in the recent past
-Have high earnings
-Are priced high relative to the rest of the market
Value Stocks:
-Priced below the market AND their peers.
Both have risks. With growth you always have to wonder when the high prices are going to correct. When they fall, they will probably fall fast. Did you get in at the middle of a long run, or at the peak?
With Value you have to wonder if you are really buying hidden gems that will bounce back for gains, or if they were cheap stocks for a reason.
