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Dirty Little Secrets with Growth Stocks

For the layman, financial planning has always been a tricky endeavor. Although professionals are available to help with this process, in many instances individual investors must follow a caveat emptor philosophy when it comes to decision making. However, even when investors are cautious and attempt to make the best decisions, problems can arise as a result of basic misunderstandings. For instance, the term “growth stock” seems to imply that growth is a prominent and notable feature of these investments. As such, based on this implied understanding, investors place their confidence in the fact that these investments will grow and produce substantial returns. Interestingly however, when one looks at the history of specific investments labeled as growth stocks, there is ample data to suggest that this term implies much more than it actually delivers.

Growth Stocks—An Overview

With the realization that the term growth stock may indeed be a misleading misnomer, it is imperative to understand how this situation occurred. A review of what has been written about the basic definition of growth stocks reveals that these investments are simply stocks that are projected to grow at a relatively rapid pace in a relatively short time period. Unlike dividend stocks which pay a specific amount each quarter, “Growth stocks don't pay dividends; they grow revenues and earnings by 20% to 50%, and are rewarded by the stock market with P/E ratios of 30 to 50.”[1] When framed in this perspective, growth stocks appear to be a panacea for all investors. With the potential for high earnings in a short period of time, growth stocks should be able to provide investors with a solid foundation for building a nest egg.

Arguably, growth stocks sound too good to be true. Unfortunately, this is because in most instances these investments do not live up to their promise. Analysts examining ongoing trends in growth stocks note that there are a number of pitfalls when it comes to these investments.[2] In particular analysts report that while some growth stocks can produce notable earnings in a relatively short period of time, others often fail to perform as well. In order to understand why this is so, investors need to consider how these investments are structured and evaluated by financial planners.

Currently, there are five common metrics that are used to evaluate and classify growth stocks: per-share earnings, cash flow, sales, per-share tangible book value and per-share dividends.[3] While these metrics provide solid benchmarks for assessing the growth of a particular stock, they are not always viable predictors of how much growth will be achieved. To illustrate this point, analysts report that of the five metrics, per-share earnings are most commonly correlated with shareholder returns. However when the 40 top growth stocks from the S&P 500 were examined with respect to this specific variable, the top performers “delivered an average annualized return of 22.8%, versus 5.1%” for the lowest performers.[4] What this effectively suggests is that what can be classified as a “growth stock” presents a wide range of variation on return.

In addition to the fact that there is a wide spectrum of variation that exists when it comes to the performance of these investments, analysts also note that a review of growth stocks and value stocks indicates that “growth stocks have underperformed value stocks over the past 14 years—and over the past 80 years.”[5] Experts further note that because growth stocks have such high projected growth rates they often receive higher valuations than value stocks. In the end, this process only serves to drive down the valuation of value stocks, making them more viable investments for purchase.[6] Thus, even though a growth stock may have the potential to yield substantial results, there is little evidence to suggest that these investments will provide investors with the financial success they are seeking.

Putting Theory Into Practice

With a general overview of growth stocks and their pitfalls elucidated, it is now possible to put theory into practice and examine how growth stocks have failed to live up their hype. To accomplish this goal, it is helpful to consider the historical development of both dividend stocks and growth stocks. Only by examining the actual returns that have been garnered on these investments will it be possible to demonstrate the paradox that is created by using the term “growth stock.”

A critical review of current literature on growth and dividend stocks shows that Jeremy Siegel examined the performance of both IBM (a growth stock) and Exxon Mobil (a dividend stock) from 1950 to 2003. According to Siegel, based on the projected growth value of IBM stock, investors that purchased IBM stock in its early days should have seen substantial returns on their investments when compared to the dividends that were being paid by Exxon Mobil during the same time period. Surprisingly however, this has not been the case. While Siegel reports that both stocks did notably well during this time period, the total return for Exxon Mobil was much higher over the long-term. Specifically, Siegel notes that:

…Investors in Jersey Standard earned 14.42 percent per year on their shares from 1950 through 2003, more than half a percentage point ahead of IBM's 13.83 percent annual return. Although this difference is small, when you opened your lockbox fifty-three years later, the $1,000 you invested in the oil giant would be worth over $1,260,000 today, while $1,000 invested in IBM would be worth less than one million dollars, some 25 percent less.[7]

As such, if the dividend from Exxon Mobil were reinvested each quarter, it would have cost the investor $13 to buy $1 of earnings in the company. In comparison, IBM investors would have to pay approximately $27 for the same $1 of earnings.[8]

Conclusion

Synthesizing the data, it seems reasonable to conclude that the term “growth stocks” engenders significant misconceptions about the performance of these investments. While it is evident that growth stocks do indeed demonstrate significant returns, when the returns they yield are compared to dividend stocks, there is no real evidence to suggest that growth stocks provide a clear cut advantage for the investor. Thus, investors must be willing to look beyond their perceptions of what they believe growth stocks can achieve. Clearly “growth stocks” are not always what they appear to be.

Bibliography

Dodge, Dan. “Microsoft.” Dan Dodge, [2006]. Accessed September 12, 2006 at: <http://dondodge.typepad.com/the_next_big_thing/2006/04/microsoft_growt.html>.

Paplava, Jim. “The investment constant.” Financial Sense Online, [2005]. Accessed September 12, 2006 at: <http://www.financialsense.com/stormwatch/2005/0408.html>.

“The problem with growth stocks.” Dow Theory Forecasts, 61(7), (2005): 5-9.

Siegel, Jeremy J. The Future for Investors: Why the Tried and True Triumph Over the Bold and the New. New York: Crown Business, 2005.