What Are Growth Stocks?

Growth lies in the eye of the beholder.

January 2023. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Growth stocks can be defined via valuations, fundamentals, or performance
  • These stocks have generated essentially zero excess returns since 2005
  • Neither has the inverse basket (low valuations, low growth, low momentum)

INTRODUCTION

When Yale history professor Sherman Kent interviewed 23 NATO officers on their interpretation of probabilistic words in 1964, the results were surprising and concerning. The probability associated with the word “probable” ranged from 25% to 95%, depending on the officer. Naturally, this begs the question of how worried a military commander should be when he is informed that an attack is probable.

Although less concerning, such differentiated perceptions are common in the investing world. Take growth stocks, how exactly are these defined?

For many financial researchers, these simply represent the inverse of value stocks, ie the most expensive ones, while investors often consider growth stocks as companies that have great fundamentals. Another definition is simply the stocks that have outperformed. Or the ones that have been dominating headlines, which were companies like Amazon or Apple for most of the past decade.

Different definitions lead to different portfolios, which makes evaluating growth-focused strategies challenging (try Finominal’s Security Analyzer). In this research article, we will explore three common types of growth stocks namely expensive, high growth, and high momentum stocks.

VALUATIONS OF GROWTH STOCKS

First, we create five indices that represent common perceptions of growth stocks. Stocks are selected on price-to-book (P/B), price-to-earnings (P/E), sales growth, earnings growth, or momentum, using the top 10% of stocks for each metric from the universe of all U.S. stocks with a market capitalization larger than $1 billion. P/B is calculated using the latest available book value, P/E with the last 12 months of earnings, sales and earnings growth based on 3 years of data, and momentum with a 12-month lookback, excluding the most recent month (read Growth: Facto