Growth is Not Enough

When you ask most investors for their favorite stocks, you'll rarely hear them share a blue-chip name like Johnson & Johnson, Kraft Foods or Wal-Mart. Instead they will tell you about some amazing growth stock that will be the next Google, Microsoft or Apple.

These investors believe that by simply buying stocks with the greatest earnings growth potential they will make money. Sadly, our research clearly shows this not to be true...not even close.

In this article, I will dispel the myth about investing in growth stocks and shine the light on a path that has more consistently paved the way to profits.

Research Says...

I know that many of your are still shaking your heads in disbelief. Certainly I must be joking, right? Unfortunately, our research details beyond a shadow of a doubt the vast underperformance of growth stocks over the past decade. Here are the results.

Projected Earnings Growth Rate	*Annualized % Return
0 - 10%	5.4%
10 - 20%	2.6%
20 - 30%	-0.2%
30%+	-9.7%
S&P 500	-3.3%

Stocks with the lowest projected growth rates actually generated the highest return of +5.4% per year. Yes, I know that doesn't sound like much, but remember the average return of the S&P 500 over that stretch was an anemic -3.3% thanks to 2 ferocious bear markets.

Each level of additional earnings growth came with decreasing levels of profits for investors. As we look at the most aggressive growth stocks, with 30%+ expected earnings growth, we find an embarrassingly low -9.7% return. This begs an obvious question....

Why Don't Growth Stocks Pan Out?

The early investors in growth stocks usually do quite well. They take the early risk when almost no one has heard of the company. As the company bangs out earnings surprise after earnings surprise, it gains more investor attention and a much higher share price.

However, at some point the company will be "priced for perfection". Meaning that the PE gets too inflated as people are so sure that the good times will just keep rolling (think of a mini version of the late 90's tech bubble).

Unfortunately the exceptional growth rarely holds up over time. At some point, as the company tries to expand rapidly, it will stumble. Even if that just means going from a 50% growth rate to a 40% growth rate. On the surface 40% still sounds great...but not to the investors who expected 50%+. So naturally the stock will tank. And tank fast.

I'm sure you've had a few of these stocks in your portfolio over the years. So I don't have to remind you how quickly the losses add up. That, in a nutshell, is the danger of investing in growth stocks.

So What Does Work?

Certainly you could look at the stats above and conclude that stocks with lower projected growth rates generally outperform. That is true. But we can do a heck of a lot better than that 5.4% return.

The key is to find stocks that exceed expectations no matter the growth rate. Meaning that a stock that is expected to grow profits by 5% and ends up growing by 7% will do very well. Ditto for a stock expected to grow 30% that ends up at 35% actual earnings growth.

I know on the surface it sounds like you need a crystal ball to predict which companies will beat their earnings projections. Gladly, it's actually much easier than you think because Len Zacks has done the hard work for you.

In the mid-1970's Len Zacks realized that stocks that had big earnings surprises continued to outperform the market over the next several months (this is what academics call the Post Earnings Announcement Drift ("PEAD")...yes, I know it sounds more like a medical problem than a means in which to invest in stocks).

But Len went a step further. He wanted to find indicators that would show him stocks more likely to have positive earnings surprises BEFORE they happened. If you could do that, then the odds of success were firmly stacked in your favor.

For the next several years Len worked feverishly to discover these indicators. Gladly for all of us he did find 4 leading indicators of future earnings surprises. Three of these measures are ways of looking at brokerage analyst earnings estimate revisions. The last being an analysis of past earnings surprises.

Each factor is potent by itself. Blending them together creates an almost unfair advantage for investors...that advantage is now called the Zacks Rank stock rating system.

I know you've probably heard the story countless times before from us. "The Zacks Rank #1 stocks have a 27% annualized return since 1988."

So if you've heard the story, then let me ask you a more personal question;

Why the heck haven't you used it??? ;-)

Yes, it's true the Zacks Rank is part of our Zacks Premium subscription service. But we give you a 30-day free trial to use this resource with absolutely no obligation to buy. And beyond the Zacks Rank for 4400 stocks, you also get our equity research reports, stock screening strategies and even our new mutual fund rank covering nearly 19,000 funds.

If you've had great success on your own as an investor, then don't bother with this free trial. You are set. However, if you think your portfolio could do better, then please take me up on this invitation to try the Zacks Rank and all our other resources built to help you outpace the market.

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Best Regards,

Steve

Stephen Reitmeister
Executive VP,
Zacks Investment Research

Steve is in charge of Zacks.com and all of its subscription services. He created Zacks Premium in 2006 to provide investors full access to the Zacks Rank and its market beating potential. Today Zacks Premium is our most popular service because it is chock full of resources to pick the best stocks and now mutual funds too. We invite you to take a 30-day free trial to see how it can help you outperform the market in the years ahead.

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