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The Limits of Active Investing in Growth Stocks

Posted by admin on June 30, 2008 in Investment Products

Research in Motion Ltd., makers of the Blackberry devices, had a rough week last week. It lost over 15% of its share value in a week. Why? It announced that its revenue growth was up 107% from the same period last year and it was profitable (84 cents per share for the three months ending May 31) BUT it fell short of expectations so the stock market reacted quite negatively, sending Research in Motion stock down 13% within 24 hours of the announcements. Punishing a stock because it makes great but not outstanding profits once again reaffirms that market expectations are like bad mother-in-laws: if you meet expectations, you were supposed to do it and if you miss them, well, you’ll never hear the end of it.

Research in Motion’s adventures last week highlight the fundamental limitation of active investing in a growth stock. The law of averages dictates at some point in time, the company simply cannot maintain the blistering pace of growth which underlines its stock price and, when the growth moderates to more conventional pace (think under 15% annual growth in profit and under 20% annual revenue growth), the stock price is punished accordingly. If the stock also does not pay any dividend then, watch out. The market is investing in the stock purely as an appreciation pay and, once growth slows down, there isn’t an underlying cash flow a dividend provides for investors to maintain its position in the stock. Smart money takes their profits from one growth stock to another (in some respects, Research in Motion is this decade’s Nortel at its peak).

Morningstar, an investor research service, showed the law of averages work against businesses increasing their revenue and profits year over year (these statistics are from Seymour Schulich’s book, Get Smarter). Of 2,214 stocks that had 20% or more sales growth in year 1 of the study, only 15.8% of those firms could maintain that sales growth by year 3 which fell again to 3.9% by year 5. In other words, approximately 96% of business cease to be growth stocks by year 5 (and I am only looking at revenue growth which is easier to obtain than earnings growth). The odds simply work against you that a growth stock will be a market darling for an extended period of time (Apple seems to be one of those expectations rather than the rule).

Paradoxically, small cap stocks (stocks with market capitalization between $300 million and $2 billion), a bastion- and frequently synonymous with growth stocks-outperformed the general market in every recession since 1950 (the Fama/French Small Cap Value benchmark outperformed the S & P 500 index in the 3 years after the 9 recessions since 1950). What do we make of these two seemingly contradictory findings?

1. Picking a particular growth stock, whether it is a small cap or large cap stock, appears to be an exercise in futility unless you have a great acumen at finding winners in the stock market which most of us do not have.
2. However, based on past data, a benchmark of small cap growth stocks tends to act as a hedge in bear markets.Emphasis on past data and benchmark. As you know, what stocks constitute benchmarks change from time to time. For small cap benchmarks, successful stocks which “graduate” to large cap status or go out of business/privatize etc. are removed from the index and other small cap/growth stocks are added into the benchmark. Thus, the benchmark will tend to have the better or up and coming growth stocks.  Or, to look at it another way, it is continuously removing the 96% of businesses that cannot maintain its growth rates by year 5 with ones who survive or new growth stocks.

The potential for a growth stock to “pop” is quite high; this is why they are so enticing to invest in and attract so much media attention. But, statistically speaking, it is hard to time the purchase of a growth stock given it could cease to be a growth stock at any point in time (is RIM at its peak? Do you hold buy now, hold on to it or sell? Who really knows in growth based technology stocks), subject to unrealistic market expectations (I am sure the Research in Motion executives were muttering in their coffees the morning after their stock fell 13%) and there is typically no dividend to mitigate downside risk.

A well-balanced portfolio for an investor with a long investing horizon should include small cap/growth stocks but this allocation is better obtained through passive investing in small cap exchange traded funds then actively trying to pick which stock will be the new Research in Motion.