Many shall be restored that now are fallen and many shall fall that now are in honor.
– Epigraph by Horace in Security Analysis (1934) by Graham & Dodd
In our May contribution we discussed the danger related to valuation risk, i.e. the danger of overpaying for the hope of growth (Montier, 2009). We documented that the expectations concerning long-term earnings growth rates of glamour stocks are overly optimistic and how this overoptimism results in inferior returns as well as (relatively) strong price drops following the publication of disappointing results. We concluded that (a) in their quest for successful growth stories investors should be careful before relying too heavily on long-term earnings growth forecasts made by financial analysts and (b) investors should avoid stocks with significantly above average valuation multiples. In this contribution we will add a new, third warning to the list: we warn to take care when using past earnings growth rates as a reliable precursor for future growth. It so happens that firms with high past earnings growth rates cannot be counted on to repeat their strong relative performance in the future; at the same time companies that over the past years have dangled round the growth group are not necessarily doomed to generate low growth. The findings warn against extrapolating past success into the future.
By custom we start with the vision of Benjamin Graham (1949) regarding the added value of past earnings trends in assessing future performance. In a second step we discuss the results of two research studies (Chan et al., 2003; Haugen, 2010) and elaborate on the important implications for growth and value investors respectively. We end with some conclusions.
-Old-School Value Investing
In chapter Group Studies of Earnings and Price Developments Benjamin Graham (1949) formulates an answer to the question “How permanent are trends?”:
Wall Street’s judgment has been influenced by past trends more than by any other single factor related to security values. The avowed object of people in the market is to anticipate future developments, and the past is held to have no significance except as it aids in such anticipation. Yet in practice it is almost the universal habit to base forecasts of future happenings on a projection of past trends. This is notoriously true of both the professional’s and the public’s view of market prospects. Nearly everyone is optimistic (or “bullish”) because the market has been enjoying a spirited advance and pessimistic (or “bearish”) after a decline. In the same way an industry or a company which has grown in the past is almost always expected to keep on progressing; those which have been on the downgrade are expected to get worse and worse.
The last attitude is expressed in categorical fashion on page 458 of Mead & Grodinsky’s book The Ebb and Flow of Investment Value, as follows: “Declining industries, therefore usually continue to decline until they reach the point where they pay nothing to the investor.”
Our own thinking during the past thirty years has been out of sympathy with this viewpoint. It is true that every established trend has a certain momentum, so that it is more likely to continue for at least a while longer than it is to reverse itself at the moment of observation. But this is far from saying that any trend may be relied upon to continue long enough to create a profit for those who get aboard. Rather extensive studies which we have made of the subject lead us to conclude that reversals of trend in every part of the financial picture occur so frequently as to make reliance on a trend a particularly dangerous matter. There must be strong independent reasons for investing money on the expectation of a continuance of past tendencies, and the investor must beware lest his weighing of future probabilities be unduly influenced by the trend line of the past. (Emphasis added)
The message is clear: past trends are not in the least a reliable guide to the future. The underlying reason has already been mentioned in our previous contribution. High growth rates and high profit margins attract rivals which results in increasing competitive pressures and downward pressure on growth and margins. On the other hand corporate bankruptcies and reorganisations will eliminate overcapacity and contribute to higher profit margins and growth rates.
In Haugen (2010) the author refers to a study by Rayner and Little (1966). Rayner and Little look at British companies over the 1951-1961 period. Firms are ranked based on growth in earnings per share over the 1951-1956 period; the same procedure is repeated for the second half of the 1950s. The ranks in the two subperiods are subsequently plotted on a graph. The rank of a company in the first subperiod is plotted on the x-axis; the rank in the second subperiod is shown on the y-axis. If past growth rates serve as a reliable guide to the future we should find a pattern similar to the one in GRAPH I. Firms with the highest relative growth rates over the past years continue to bring this performance in the following years; firms that have underperformed in the past will continue to do so in the future.
GRAPH I: THE PAST AS A RELIABLE GUIDE TO THE FUTURE
If growth rates in the two subperiods are unrelated a pattern similar to the one in GRAPH II will emerge.
GRAPH II: PAST GROWTH NOT A RELIABLE PRECURSOR FOR FUTURE GROWTH
Rayner and Little find a pattern similar to GRAPH II. Using past earnings growth rates as a guide to the future is about as reliable as the fifty-fifty odds in flipping a coin. The study by Rayner and Little dates back from 1966. The evidence has been updated in “The Level and Persistence of Growth Rates” by Chan et al. (2003) for US companies. The study concerns the 1951-1998 period. The researchers verify whether firms that have demonstrated consistently high or low past growth rates have continued this pattern in the future. They proceed in the following way. At the end of each year Chan et al. select the firms that have realised superior past growth over the past three years. They subsequently check the number and percentage of companies that continue to deliver this strong relative performance in the following years. The results are shown in GRAPH III.
For year one in GRAPH III there are 259 firms that time and again realised an above-median growth in earnings over the past three years and that still exist after one year. 125 out of the 259 firms (which is 48.3 percent) succeed in realising an above-median growth in earnings for the fourth year in a row. If the possibilities of outperformance were simply a matter of chance, we would expect to find 130 companies (259*0.5) with above-median earnings growth for four consecutive years. Concerning the second year, 240 companies have realised an above-median growth in earnings over the past three years in a row and survive the upcoming two years. 57 firms out of the 240 – which is 23.7 percent – realise an above-median earnings growth during five