Blinded by Growth (Digest Summary)

Everybody enjoys a growth story, but investors ought to consider that growth and returns are not positively correlated. Over the 112 years that the author studies, economic growth and equity returns show a negative correlation. Similarly, in this time period, equity returns and company growth are negatively correlated; investing in high-growth companies often results in relatively low returns for investors. There are a number of reasons for this result, including the eagerness of investors to participate in fast-growing sectors of the economy, which leads to a tendency to overpay.

Whether economic growth is measured as growth in GDP or GDP per capita, it shows a negative correlation with equity returns. The result does not change significantly when returns in local currency are compared with those in nondomestic currency. The author identifies three reasons for this outcome. First, companies that benefit most from growth in a certain country are typically based outside that country, particularly in the case of multinational companies that represent a disproportionately large share of equity returns in fast-growing economies. Second, large companies tend to sell globally and thus do not suffer from downturns in their local markets. Third, investors have a tendency to overpay for growth because of their eagerness to participate in the growth perspective.

In a similar way, fast-growing companies tend to have relatively low equity returns. Superb corporate performance generally appears to be associated with low returns. For example, investors during the internet bubble were willing to buy shares trading at P/E multiples in excess of 100, expecting that they would be able to sell them at even higher multiples. From the start of 2006 to the end of June 2010, Google showed a growth in earnings of 358%. The holding-period return for the same period was 7.3%, which consisted solely of capital gains because Google did not pay any dividends during the period. As Google’s earnings grew, its P/E moved in the opposite direction, thus leading to a lower equity return.

Growth investors are typically willing to pay high multiples to invest in companies with high growth potential. In contrast, value investors choose mature companies with moderate growth forecasts, which are often temporarily less attractive to other investors and thus have low multiples. From 1927 to 2011, value investors underperformed as often as growth investors but the annualized returns differ significantly: Value investors achieved a 12.8% return, whereas growth investors achieved a 9.5% annualized return.

The author uses 112 years of data (1900–2011) to analyze the relationship between economic growth and equity returns. Because markets and economies have developed significantly during this period, data from 1970–2011 are used to validate the results.

The relationship between company growth and equity returns is based on available data for such companies as Google and Amazon and is supported by an analysis of the Datastream World Market equity index over two consecutive five-year periods. The period of 1995–1999 can be categorized as bullish and showed an 8.3% annualized growth in earnings. The next period (2000–2004) was bearish and showed an annualized growth of 8.5%. During the first period, investors’ willingness to overpay pushed price-to-earnings ratios up, thus enhancing returns. During the second (bearish) period, price-to-earnings ratios were pushed down and shareholder value was destroyed.

The author provides the data to support what many value investors have long said: Investors are willing to overpay for something that shows growth. Investors typically do not want to lose out or be contrary to the market. But the data show that when everyone else has already invested, it may be time to look elsewhere.