Don't Overpay Today for Growth Tomorrow

by Greg Forsythe, CFA, Senior Vice President, Schwab Equity Ratings®, Schwab Center for Financial Research
Updated November 17, 2008

Excerpted from the March 2007 issue of Schwab Investing Insights®, a monthly publication for Schwab clients.

Any list of long-term stock market winners is dominated by companies that grew earnings per share (EPS) much faster than market averages. Therefore, the key to future portfolio success must be to buy stocks with the highest earnings growth prospects, right? Wrong!

If each year from 1986 to 2006 you had purchased the 20% of stocks from the 3,200 largest market capitalization public companies with the highest five-year EPS growth forecasts, your portfolio would have lagged the average stock by about 1.5% annually while being much more volatile.

High growth expectation stocks often disappoint
There are two primary reasons why stocks with high EPS growth forecasts tend to underperform:

Stocks with high growth expectations tend to have high current valuation levels—that is, high price-to-earnings (P/E) ratios. Stocks with strong earnings potential are typically well-known, and investors are usually willing to "pay up" for potential growth.
High expectation stocks tend to deliver actual earnings growth far short of optimistic forecasts. When such stocks report negative earnings surprises, prices tend to fall and P/Es to contract.

Current valuation trumps growth forecasts
To better understand the interaction of current valuation and prospective growth, we assigned stocks into "portfolios" at a point in time according to their P/E ratios and five-year EPS growth rate forecasts, and measured total returns for these portfolios over the subsequent year. We repeated this process for all stocks with positive EPS among the 3,200 largest market-cap stocks each month from 1986 to 2006. The "P/E vs. Growth" matrix below summarizes our results (darkest shaded portfolios outperformed the market average).

Growth investors might be dismayed to see in the table's bottom row that stocks with high earnings growth forecasts ("GROWTH" columns) have tended to deliver lower total returns than stocks with lower growth forecasts ("VALUE" columns). On the other hand, value investors might be pleased to see in the right column that stocks with low P/Es ("CHEAP" rows) tended to deliver higher total returns than stocks with higher P/Es ("PRICEY" rows).

The average percentage of stocks falling into each cell (shown in parentheses, with blank cells having no observations) shows the strong general tendency for stocks with high EPS growth expectations to have higher P/E ratios than stocks with lower EPS growth forecasts.

Don't overpay for future growth
Many analysts tout the "PEG ratio" as a tool to help investors avoid overpaying for prospective growth. Just as the P/E is a measure of what investors are paying for current earnings, the PEG—short for P/E to Growth—measures what value investors place on future growth. In its simplest form, the PEG ratio is computed by dividing a stock's current P/E ratio by its consensus five-year EPS growth rate forecast. So if a stock's price is $20, its EPS over the last four quarters is $1 and its consensus growth forecast is 15% annually, then that stock's PEG is 1.33. The idea is that if an investor were considering two stocks with the same forecasted EPS growth rate, then the stock with the lower PEG would be considered more attractively valued.

Looking down the columns in the matrix, you'll see that lower P/E stocks have tended to provide higher historical returns for any level of expected EPS growth. Interestingly, this effect is more prominent among value stocks with low EPS growth expectations than among growth stocks with high EPS growth forecasts. In other words, high growth expectation stocks with low PEG ratios still tend to underperform.

Don't overpay for "quality" growth
We've seen that paying up for prospective growth has not usually been a good idea. What about paying up for quality? While quality is difficult to define, some analysts advocate trying to find companies that have some type of competitive advantage that makes them more likely to sustain long-term, above-average earnings growth.

Adding to the appeal of this strategy, companies often suggested as having quality growth are usually industry leaders with solid track records of earnings and stock-price performance. We believe it's possible through rigorous research to identify companies that might continue to grow earnings faster than market averages. But remember, great companies now aren't always great growth stocks in the future.

It feels good buying the stocks of brand-name companies, but therein lies the problem. A good admonition in investing is "if it feels good, don't do it," as the demand for feel-good investments tends to make them overpriced. Five years ago, no one would have faulted you for buying such quality growth stocks as Home Depot, Pfizer or Wal-Mart. From 2002 to 2006, these companies delivered EPS growth of 148%, 77% and 92%, respectively. Unfortunately, these firms' stock prices are all lower today than they were on January 1, 2002, and the CEO of Home Depot was recently fired for this very reason.

The problem for shareholders of these companies was that their P/E ratios of 43, 33 and 39, respectively, were simply too high five years ago even for the strong EPS growth these firms subsequently delivered. The lesson: Just as one can overpay for high growth prospects, one can also overpay for high quality.

Tilt the odds in your favor
Building a portfolio of stocks with the greatest likelihood of outperforming the market over the long run is a process of tilting the odds in your favor. While there are exceptions to every rule, history suggests that buying stocks with high EPS growth forecasts or high P/Es is fighting the odds. Here are three useful rules of thumb:

Avoid stocks with P/E ratios above 25 (use EPS over the last four quarters from continuing operations before extraordinary items).
Avoid stocks with five-year consensus EPS growth rate forecasts above 25.
Avoid stocks with negative current EPS and five-year consensus EPS growth forecasts above 15%.

Two better solutions
Perhaps the most practical lesson that can be taken from our "P/E vs. Growth" matrix is to ignore consensus five-year EPS growth forecasts altogether and simply emphasize buying stocks with low P/E ratios. While a diversified portfolio of low P/E stocks will not always outperform and definitely makes a bet on value stocks, historically such portfolios have outperformed the broad stock market and been simultaneously less volatile—not a bad combination.

We believe an even better solution would be to combine low P/E investing with Schwab Equity Ratings®.

Clients can do this kind of research on Schwab.com. Go to the Quotes & Research tab, then the Stocks tab. Next, click on Create Your Own Screener. Among the many search criteria: P/E and PEG ratios, five-year expected earnings growth and Schwab Equity Ratings.

If you wish to take advantage of Schwab Equity Ratings without purchasing the numerous stocks necessary to achieve proper diversification, you can choose mutual funds powered by Schwab Equity Ratings, which tends to favor low P/E stocks.

Important Disclosures

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing. Investment value and return will fluctuate such that shares, when redeemed, may be worth more or less than original cost.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security. Any investments and strategies mentioned here may not be suitable for everyone. Examples provided are for illustrative purposes only and not reflective of results you can expect to achieve. All expressions of opinion are subject to change without notice.

Schwab Equity Ratings are assigned to approximately 3,000 of the largest (by market capitalization) U.S.-headquartered stocks using a scale of A, B, C, D and F. Schwab's outlook is that A-rated stocks, on average, will strongly outperform, and F-rated stocks, on average, will strongly underperform the equities market over the next 12 months. Schwab Equity Ratings are not personal recommendations for any particular investor. Before buying, investors should consider whether the investment is suitable for themselves and their portfolio.

All charts and research have been compiled from publicly available, proprietary and/or licensed data.

Past results are not indicative of future performance.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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