Growth: Factor Investing Sinning?

Paying for Emotional Happiness?

July 2019. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Growth stocks outperformed the US stock market since 1992
  • However, the higher returns are explained by higher betas
  • The long-short factor performance was negative, even if adjusted for other factor exposure

INTRODUCTION

Given a choice between investing in a fast-growing company with great management versus one with declining sales and too much leverage, most investors would likely pick the former. Rephrasing the question between buying a Growth versus a Value stock, however, would likely lead to most investors choosing the later, which highlights inconsistent investment behavior.

Hundreds of research papers have been published on the Value factor highlighting positive excess returns across stock markets and asset classes. In contrast, there is almost no literature, aside from marketing materials, supporting the Growth factor.

However, there is a significant difference between how Growth stocks are defined in academic research versus selected in portfolios of systematic investment products like smart beta ETFs. In research, Growth stocks are typically viewed as expensive stocks, which represents the short portfolio of the Value factor. If the Value factor generates positive abnormal returns over time, then excess returns from Growth stocks must be negative (read Factors: Correlation Check).

In contrast to research, most investment products focused on Growth stocks select stocks based on various backward-looking accounting metrics like sales or earnings growth, which does not necessarily equate to selecting the most expensive stocks.

In this short research note, we will analyze the Growth factor as seen in systematic investment products.

METHODOLOGY

We focus on the Growth factor in the US stock market, which we define by a combination of the three-year sales-per-share and earnings-per-share growth. Only stocks with a minimum market capitalization of $1 billion are included. Portfolios are rebalanced monthly and each transaction incurs costs of 10 basis points.

BREAKDOWN BY SECTORS

Many investors use Growth and technology