When you ask most investors for their favorite stocks, you'll rarely hear them share a blue chip name like Johnson & Johnson, Kraft Foods or WalMart. Instead they will tell you about some amazing growth stock that will be the next Google, Microsoft or Apple.
These investors believe that by simply buying stocks with the greatest earnings growth potential that they will make money. Sadly our research clearly shows this not be true...not even close.
In this article I will dispel the myth about investing in growth stocks just for growth's sake. Instead I am going to shine the light on a path that has more consistently paved the way to profits.
I know that many of your are still shaking your heads in disbelief. Certainly I must be joking, right?
Unfortunately our research details, beyond a shadow of a doubt, the vast underperformance of most growth stocks over the past decade. Here are the results.
*The study had a 4 week rebalancing of stocks between 1/7/2000 and 2/18/2011
Stocks with the lowest projected growth rates actually generated the highest return of +9.5% per year. Each level of additional earnings growth came with decreasing levels of profits for investors. As we look at the most aggressive stocks, with 30%+ expected earnings growth, we find an embarrassingly low +1.3% return. This begs an obvious question...
Why Don't Most Growth Stocks Pan Out?
The early investors in growth stocks usually do quite well. They take the early risk when almost no one has heard of the company. As the company bangs out earnings surprise after earnings surprise, it gains more investor attention and a much higher share price.
However, at some point the company will be 'priced for perfection'. Meaning that the PE gets too inflated as people are so sure that the good times will just keep rolling (think of a mini version of the late 90s tech bubble).
Unfortunately the exceptional growth rarely holds up over time. At some point, as the company tries to expand so rapidly, it will stumble. Even if that just means going from a 40% growth rate to a 30% growth rate. On the surface 30% still sounds great...but not to the investors who expected 40%+. So naturally the stock will tank. And tank fast.
I'm sure you've had a few of these stocks in your portfolio over the years. So I don't have to remind you how quickly the losses add up. That, in a nutshell, is the danger of investing in growth stocks.
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So What Does Work?
Certainly you could look at the stats above and conclude that stocks with lower projected growth rates generally outperform. That is true. But we can do a heck of a lot better than that.
The key is to find stocks that exceed expectations no matter the growth rate. Meaning that a stock expected to grow profits by 5% and ends up growing by 7% will do very well. Ditto for a stock expected to grow 30% that ends up at 35% actual earnings growth.
I know on the surface it sounds like you need a crystal ball to predict which companies will beat their earnings projections. Gladly it's actually much easier than you think because Len Zacks has done the hard work for you.
In the mid-1970s Len Zacks realized that stocks that had big earnings surprises continued to outperform the market over the next several months. This is what academics call the Post Earnings Announcement Drift...(yes, I know it sounds more like a medical problem than a means in which to invest in stocks ;-)
But Len went a step further. He wanted to find indicators that would show him stocks more likely to have positive earnings surprises BEFORE they happened. If you could do that, then the odds of success were firmly stacked in your favor.
For the next several years Len worked feverishly to discover these indicators. Gladly for all of us he did find 4 leading indicators of future earnings surprises. Three of these measures are ways of looking at brokerage analyst earnings estimate revisions. The last being an analysis of past earnings surprises.
Each factor is potent by itself. Blending them together creates an almost unfair advantage for investors... that advantage is now called the Zacks Rank stock rating system.
Our Zacks #1 Ranked strong buy stocks have produced an average return of +19.2% over the same 11 year time frame as the study noted above. That more than doubles the average of the best stocks from that study. Going back even further to 1986, we find that these #1 ranked stocks have produced a +26% average annual return.
Aye, But Here's the Rub
We so often talk about the Zacks #1 Ranked stocks and their great track record. However, there are over 220 of these Strong Buy stocks to consider at any given time.
That is fine if you are a professional investor with 60-80 hours per week to focus on researching the full list. For the rest of you, it's usually better to consider a hand-selected group of these stocks that you can more easily put into your portfolio.
My Reitmeister Trading Alert portfolio currently has 9 stocks that fit the bill. Normally this portfolio is closed to new members. But we are opening it up once again for a limited time. If you want to learn more, then best do so before it closes up again on Monday October 29th at midnight.
Steve Reitmeister has been with Zacks since 1999 and currently serves as the Executive Vice President in charge of Zacks.com and all of its leading products for individual investors. He is also the Editor of the Reitmeister Trading Alert.
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