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Strong Growth Rates and Upward Stock PricesThe prospect of explosive growth in sales and earnings lures many investors to the realm of aggressive growth stocks. Gurus are always talking about the correlation between strong growth rates and stock price appreciation. They are correct that actual growth in earnings correlates well with share price gains, however, unrealistically projected growth rates can spell disaster for shareholders. Earnings estimate revisions are a much better predictor of stock gains than high growth rates.
Beware Lofty Analyst Projections
Most investors assume that it is a good sign if analysts are predicting very high earnings growth rates over the next five years, but this often wrong. Why so? Basically analysts are not good at seeing too far into the future. Compounding the problem, the market tends to overpay for these analysts’ rosy forecasts. High growth rates exceed 35%-45% per year.
Not even the greatest analyst in the world knows what is going to happen years into the future. Analysts take their cues from other analysts and the market itself when estimating long-term growth rates. This essentially means that when you buy high-growth rate stocks, you are buying a company that both the analysts and the market believe is in a hot growth area. This is dangerous because this growth often fails to materialize, and these stocks usually trade at rich valuations. Put these two together, and it could be a recipe for trouble.
What Does Zacks Say?
Mitch Zacks, in his book Ahead of the Market, did some empirical research on this topic and found some interesting results. He constructed five portfolios from the 3,300 largest companies based on the consensus long-term earnings growth estimate. The portfolios were rebalanced monthly, and the returns calculated from October 1987 to September 2002. Portfolio #1 contained the “lowest growth rate” stocks, while Portfolio #5 contained the “highest growth rate” stocks.
Mitch found that Portfolio #1 generated a return of 11.4%, while Portfolio #5 lost 0.6% annually over that time period. Based on this data, it seems apparent that stocks which analysts collectively believe will exhibit the strongest earnings growth over the next five years dramatically under-perform the market. So what is the answer?
Enter Earnings Estimate Revisions
A company experiencing increasing earnings estimates is a whole different ball of wax. Here’s why. Upward estimate revisions mean that analysts expect earnings to be higher in the coming year compared to just a few months ago. Basically, these companies’ immediate earnings outlooks are improving. This is in contrast with an analyst speculating that a company will be doing well five years down the road.
Stick with estimate revisions as the main predictor of stock prices, rather than pie-in-the-sky forecasts for earnings growth rates many years down the line. Your portfolio will thank you for it.
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