David Fruitman, CFA, is vice-president and portfolio manager at STYLUS Asset Management Inc.; Brennan Carson, CFA, is vice-president of client service and business development at the same firm.
Money managers who profess to follow very similar investing philosophies often wind up with wildly dissimilar results. How is this possible?
Our research shows that performance is closely tied to precisely which factors managers choose to examine.
In a previous column, we addressed the confusion felt by many investors at the widely divergent performance experienced by value-oriented mutual funds, all of which promise to invest according to a value philosophy. We explained that successful value managers were more likely to incorporate certain earnings-based factors in their decision-making.
Today, we'll switch gears and examine whether the same factors that helped improve the performance of value stocks can also help improve the performance of growth stocks. If they can, then these factors should be used by all managers, regardless of their investment philosophy.
Our test involved examining the historic performance of two growth portfolios – one that simply owned high growth stocks, and another that favoured owning high growth stocks with additional characteristics focused on earnings.
We assumed that both portfolios selected stocks that were reinvesting a high proportion of their profits into their operations and whose profits were expected to increase in the next year – two common measures of growth. The difference between the two portfolios was that the manager of Growth Fund A focused simply on buying stocks with the highest growth, while the manager of Growth Fund B preferred to own the highest growing stocks with what we define as "good earnings," as identified by three key characteristics:
– Their earnings have recently grown;
– They have recently generated better-than-expected earnings;
– Analysts have raised their estimates of future earnings for the stock.
Using the CPMS/Morningstar's back-testing program and real-time database, we selected each 40-stock portfolio from the S&P/TSX Composite Index. At the end of every month, we removed stocks that no longer fit the criteria. We replaced any stock we removed with the stock that ranked highest on our criteria. Each test was conducted using monthly data from December, 1985, to December, 2012.
So what impact does good earnings have on growth portfolios?
Growth Fund A (the one that simply bought the fastest growing stocks) had an annualized return of 3.7 per cent per year over the 27-year test period, underperforming the benchmark S&P/TSX Composite Index's return of 8.2 per cent over the same period.
Growth Fund B (with the three earnings-related factors as part of the investment strategy) performed much better, generating an annualized return of 11.8 per cent per year over the past 27 years, easily outperforming the index.
In addition, Growth Fund B outperformed Growth Fund A in 24 of the 27 years tested. The performance of Growth Fund B was also more consistent, generating positive returns in 22 out of 27 years versus a more modest 17 out of 27 for Growth Fund A.
The test results clearly show that good earnings make a significant difference in the long-term performance of growth stocks, as they did with value stocks, helping to generate more consistent and superior returns.
Since looking for good earnings results in improved performance for both value and growth investing, it is imperative that all investment managers, no matter what their investment philosophy, pay attention to these factors.
It is equally important for investors to be pro-active and ask the fund manager or their adviser whether good earnings is part of their investment decision-making strategy and more importantly, to ask for proof.
Good managers should have the resources necessary to demonstrate the current and historic style of their funds and their underlying approach to stock selection.