The obsession with growth investing

(MoneyWatch) Investors seem to be obsessed with investing in growth strategies, whether it's investing in companies with faster growth of earnings or dividends, or countries with faster rates of economic expansion. They seem to believe that the faster growth must inevitably lead to higher returns. That's the conventional wisdom. But like so much of conventional wisdom about investing, it's wrong.

Investing in growth stocks

It's certainly true that growth stocks (stocks with high price-to-earnings, book-value, sales or cash-flow ratios) have a faster rise in earnings. However, growth stocks have produced lower returns than the stocks of value companies (stocks with low ratios). Using the Fama-French Research Indexes, we see that the faster growing large growth stocks returned 9.3 percent per year for the period 1927-2012, while large value stocks returned 11.6 percent per annum. And the faster growing small growth stocks returned 8.7 percent per year while small value stocks were returning 14.8 percent per year.

Investing in stocks with rapid dividend growth

Using the Center for Research in Security Prices at the University of Chicago (CRSP), we'll compare the cap-weighted returns of the top quintile of the dividend growth ranking each year. Since the growth rates start in 1981, the returns start in 1982. For 1982-2011, the top quintile of dividend growth stocks provided an annualized return of 11.1 percent, just 0.1 percent higher than the return of the S&P 500 Index -- a difference with no statistical significance. It's also worth noting that over the same period the Russell 1000 Value Index returned 11.5 percent and the Russell 2000 Value Index returnd 11.9 percent.

Investing in Faster Growing Economies

Studies have found that there is actually a negative correlation between rates of GDP growth and stock returns -- exactly the opposite of what investors believe. Here we present the evidence from Credit Suisse's Global Investment Returns Yearbook 2010. Elroy Dimson, Paul Marsh and Mike Staunton found that countries whose real GDP per capita grew faster than average over the 110-year period 1900-2009, did not produce higher real equity returns than their slower growing peers.

In addition, Jim Davis of Dimensional Fund Advisors looked at emerging markets for the period 1990-2005 to see if faster earnings growth meant higher returns. He found that there wasn't much difference in returns between the stock markets of faster-growing economies and slower growing economies.

The lessons: You should never confuse growth with investment returns and markets are pretty efficient at pricing in expected growth. In other words, they price for risk, not growth. Riskier investments have higher expected returns, not faster growing ones.

At least you now have the facts, and hopefully a better understanding of the nature of these strategies and the risks they entail. Informed investors generally make better decisions.

Image courtesy of taxbrackets.org.

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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