The modern factor investing thoughts around growth can be traced back to Eugene Fama and Kenneth French’s 1992 paper: The Cross-Section of Expected Stock Returns

Except the word “growth” was never mentioned in the paper…

It’s hard to pinpoint when growth became the de-facto opposite of value, but the justification given revolves around the idea that “Expensive stocks need to grow into their valuations”. The issue with that is it involves no measure of what current growth rates of those expensive stocks are. It’s wholly possible that the cheap stocks have higher growth rates and the expensive stocks have lower growth rates.

Once everyone started conflating expensive with growth, it is easy to see why growth was shunned. Here is a backtest from the French Data Library.

1996 – June 2022 of the cheapest and most expensive deciles (10%) using a combination of book value, earnings, cash-flow and dividend yields:

• Cheap: 15.4% CAGR
• Growth Expensive: 8.2% CAGR

What we know, from more than just Fama/French, is that expensive stocks tend to do poorly over long periods of time. All else equal, you want cheap, not expensive. But growth does not mean expensive.

Growth: From Raw to Thoughtful

Let’s start with the basics. Growth should equate to growth in a fundamental data point. Growth in sales, growth in income, growth in profitability, etc. We want to measure actual growth (Ignoring valuation for now).

The easiest measure would be sales. Most companies have sales, even if they are unprofitable. So the first test was pretty simple. What if you bought the 100 companies with the highest year-over-year (YoY) sales growth and rebalanced every quarter? Turns out you did horribly.

We will use the same time period for all the tests on this post. 1996 – June 2022. Russell 1000 Universe. Equal-Weight Top 100 Sorts. Re-balanced Quarterly.

• Russell 1000: 9.2% CAGR / 18.1% Volatility
• Top 100 YoY Sales Growth: 3.9% CAGR / 30.1% Volatility

Alrighty then. Maybe we should ignore growth even if it’s not the same as expensive? Unfortunately I’m a masochist, so I pushed forward.

My first thoughts we’re two-fold. Short-term sales growth can be pretty noisy AND sales themselves don’t help us identify profitable companies (Major key).

So I figured why not try a few different rules. Lets try YoY Sales Growth with only profitable companies and let’s also try looking at sales growth over 5 years:

• Russell 1000: 9.2% CAGR / 18.1% Volatility
• Top 100 YoY Sales Growth (Profitable Companies): 9.4% CAGR / 25.3% Volatility
• Top 100 5 Yr Sales Growth: 9.1% CAGR / 27.2% Volatility

Much better there. Still nothing to write home about, but with a little effort, we at least caught back up to the market. Next, what if we combined these new rules? How about 5 yr Sales Growth with only profitable companies?

• Russell 1000: 9.2% CAGR / 18.1% Volatility
• Top 100 5 Yr Sales Growth (Profitable Companies): 12.6% CAGR / 24.9% Volatility

Now we are talking. Very solid outperformance and volatility continues to come down. I wanted to try one last rule which changed it from Sales Growth to Sales per Share Growth. I thought this might be helpful as it will boost up companies who are buying back shares (Typically a good thing).

• Russell 1000: 9.2% CAGR / 18.1% Volatility
• Top 100 5 Yr Sales per Share Growth (Profitable Companies): 13.3% CAGR / 24.5% Volatility
• Top 100 YoY Sales Growth: 3.9% CAGR / 30.1% Volatility

There we go. Some nice improvements. We went from the most basic growth measure, which had horrible results, to a more thoughtful growth measure, which had great results. 4% outperformance over the index with 100 stocks is an impressive achievement.

I will post all of the tests I did at the end of the post, but just for reference, the best growth test was Free Cash Flow (FCF) per Share Growth:

• Russell 1000: 9.2% CAGR / 18.1% Volatility
• Top 100 1 Yr Free Cash Flow per Share Growth: 14.2% CAGR / 21.3% Volatility

Those numbers are pretty spectacular. 5% outperformance versus the index.

A couple caveats before I move on. This is just one time period. 26.5 years is not a be all end all. Especially when that period covered two well known growth periods (Late 90s and 17′-20′). No transactions costs included. Etc. Take this whole post with a grain of salt =)

Growth: Add-On

So it turns out growth may not be that bad after all. Let’s see if our thoughtful growth measures can help value out as well?

Again, same universe and parameters from above. The two value measures I will use are my two personal favorites: EV/EBIT and FCF Yield:

• Russell 1000: 9.2% CAGR / 18.1% Volatility
• Top 100 Cheap EV/EBIT: 13.7% CAGR / 24.9% Volatility
• Top 100 FCF Yield: 13.3% CAGR / 25.4% Volatility

Very good results. Despite the value “struggles” of recent years, it has still been a wonderful long-term strategy. And interesting to me that the value sorts and the thoughtful growth sorts BOTH outperformed in this time period.

But can growth help value?

To find out, I first sorted the Top 200 value names by both EV/EBIT and FCF Yield. Then, within those 200 names, I selected the Top 100 names by 5 Yr Sales per Share Growth (Profitable Companies):

• Russell 1000: 9.2% CAGR / 18.1% Volatility
• Top 200 Cheap EV/EBIT -> Top 100 Sales per Share Growth (Profitable Companies): 14.1% CAGR / 23.2% Volatility
• Top 200 FCF Yield -> Top 100 Sales per Share Growth (Profitable Companies): 15.2% CAGR / 21.3% Volatility

EV/EBIT only marginally improved, but still improved. FCF Yield added almost 2% and added a large volatility reduction. So higher returns and lower volatility and tracking error…I would call that a win-win.

Conclusion

The truth is, most folks will still ignore growth. And I get it. There is no reason to think growth will continue, growth data is noisy, you get trapped in cyclicals, etc. For me though, you could say similar things about any factor. They all have downsides…

But I think looking at thoughtful growth sorts is a worthwhile exercise. So go ahead and ignore quarterly or YoY Revenue Growth. Move down the income and cash-flow statements. Extend your lookback periods. Focus on profitable companies. And consider measuring growth in “per Share” values.

And for those tied to other factors like value, simply use it as a sanity check. Same with quality. Look at the whole picture.

At the end of the day, future growth, within the context of today’s price, is the holy grail.

By no means is it easy to get right or judge, but when you look back and decompress returns, they can be broken down into 3 buckets:

Fundamental Growth + Shareholder Yield + Multiple Change = Total Return

I don’t understand why we wouldn’t want to at least look at and think about all 3 as opposed to 1-2.

Let me know where I’m wrong and have some fun out there!

Appendix

Here are the full tests results of the various growth style tests I ran (Some are “profitability” or “value” measures). It’s a lot =)

As a reminder, the results are 1996 – June 2022. Russell 1000 Index. Equal Weight 100 names and quarterly re-balanced.

• Russell 1000: 9.2% CAGR / 18.1% Volatility
• Top 100 YoY Sales Growth: 3.9% CAGR / 30.1% Volatility
• Top 100 YoY Earnings per Share Growth: 8.9% CAGR / 23.2% Volatility
• Top 100 5 Yr Sales Growth: 9.1% CAGR / 27.2% Volatility
• Top 100 YoY EBIT Growth: 9.4% CAGR / 24.9% Volatility
• Top 100 YoY Sales Growth (Profitable Companies): 9.4% CAGR / 25.3% Volatility
• Top 100 YoY Operating Cash Flow Growth: 9.8% CAGR / 23.2% Volatility
• Top 100 YoY Operating Cash Flow per Share Growth: 10.4% CAGR / 22.9% Volatility
• Top 100 YoY Earning Growth: 10.6% CAGR / 16.4% Volatility
• Top 100 5 Yr EBIT Growth: 11.1% CAGR / 23.2% Volatility
• Top 100 5 Yr Gross Margin Growth: 11.2% CAGR / 22.9% Volatility
• Top 100 5 YR Free Cash Flow Growth: 11.4% CAGR / 19.0% Volatility
• Top 100 5 Yr EBIT Margin Growth: 11.5% CAGR / 21.4% Volatility
• Top 100 5 Yr Sales per Share Growth: 11.6% CAGR / 26.4% Volatility
• Top 100 5 Yr Earnings Growth: 11.7% CAGR / 21.8% Volatility
• Top 100 TTM EBIT Margins: 11.9% CAGR / 18.7% Volatility
• Top 100 5 Yr Earnings per Share Growth: 11.9% CAGR / 23.6% Volatility
• Top 100 1 Yr Return on Assets: 12.3% CAGR / 21.4% Volatility
• Top 100 5 Yr Return on Asset Growth: 12.4% CAGR / 20.2% Volatility
• Top 100 TTM Gross Margins: 12.5% CAGR / 23.5% Volatility
• Top 100 5 Yr Sales Growth (Profitable Companies): 12.6% CAGR / 24.9% Volatility
• Top 100 5 Yr Avg. Return on Equity: 12.6% CAGR / 19.7% Volatility
• Top 100 1 Yr Return on Equity: 12.7% CAGR / 19.5% Volatility
• Top 100 3 Yr Avg. Return on Equity: 12.7% CAGR / 19.8% Volatility
• Top 100 5 Yr Return on Equity Growth: 12.8% CAGR / 19.8% Volatility
• Top 100 1 Yr Return on Invested Capital: 13.1% CAGR / 20.5% Volatility
• Top 100 5 Yr Sales per Share Growth (Profitable Companies): 13.3% CAGR / 24.5% Volatility
• Top 100 Free Cash Flow Yield: 13.3% CAGR / 25.4% Volatility
• Top 100 Cheap EV/EBIT: 13.7% CAGR / 24.9% Volatility
• Top 100 5 Yr Operating Cash Flow per Share Growth: 13.7% CAGR / 21.4% Volatility
• Top 100 TTM Gross Margin (Profitable Companies): 13.9% CAGR / 19.8% Volatility
• Top 100 1 Yr Free Cash Flow per Share Growth: 14.2% CAGR / 21.3% Volatility