‘Growth’ is not the same as ‘growth’

The time has come for me to address one of those ‘elephants in the room’ that lies beneath the many meanings of a single word. In investing, we often talk about growth investing, but unlike value investing, where there are differences in how to measure ‘value’ but there is at least a commonly accepted definition of what ‘value’ is, there is no such common definition of what the word ‘growth’ in growth investing means.

If you look into the academic literature on investment styles, growth investing is typically defined as the opposite of value investing, i.e. stocks that show expensive valuation metrics. This is typically how I use the term ‘growth investing’ in these posts as well since it makes my life easier when I don’t have to write about stocks with high P/B-ratios or high P/E-ratios all the time (I do enjoy shorthand terms as much as anyone, even if they are not entirely correct).

Meanwhile, if you talk to managers of growth funds or look into the definitions of growth indices in equity markets you will encounter another definition of ‘growth’. There, growth stocks are usually defined as stocks with high past or future sales, cash flow, or earnings growth. The notion of growth stocks there comes from discounted cash flow models where the growth of future cash flows is a key driver of valuations.

In theory, stocks with high future cash flow growth should also demand higher valuation relative to current earnings or book values. That is simply the result of calculating the net present value of future cash flows and comparing it to the status quo in earnings or book equity. And in general, that holds true.

The chart below is from an in-depth analysis of the topic by Frederic Lepetit from the Amundi Institute. It shows the trailing P/B-ratio and P/E-ratio of portfolios of North American stocks as defined by the academic value criterion (Value_Q1 = 20% stocks with lowest valuations), the academic growth criterion (Value_Q5 = 20% stocks with highest valuations), and the practitioner growth definition (Growth_Q1 = 20% stocks with highest sales and earnings growth).

Valuation of growth stocks for different definitions of ‘growth’

Source: Lepetit (2023)

However, when we look at the regional composition or sector composition of the growth stock portfolio, you might be surprised how little overlap there is between the two definitions. The chart below shows the overlap between the growth portfolio as defined by ‘high valuations’ vs. the growth portfolio as defined by ‘high sales and earnings growth’ for a global equity portfolio. The average overlap by region is a mere 40% and at no point does the overlap exceed 70%. In other words, growth portfolios as defined by academics look similar by valuation metrics but are in fact quite different from growth portfolios as used by practitioners.

Regional overlap of global growth portfolios

Source: Lepetit (2023)

This also has implications for the performance of growth portfolios as defined by academics and practitioners. My final chart below shows the relative performance of the growth portfolio defined by high sales and earnings growth vs. the growth portfolio defined by high valuations. Not only does the practitioners’ growth portfolio outperform the academics’ growth portfolio by some 50% over 25 years (or some 1.6% p.a.), the correlation between the two portfolios is a mere 0.6. That is extremely low for two portfolios that are commonly considered to be interchangeable.

Growth as defined by practitioners outperforms growth as defined by academics

Source: Lepetit (2023)

The bottom line is that the academic definition of ‘growth investing’ isn’t really a proper growth investment style. It is an investment style that invests in overvalued stocks. And the performance difference shown above also means that growth investing does not deserve the ridicule that is often targeted at it by academics and value investors who say that growth investors simply buy a load of glamour stocks at high valuations and then hope they will become even more expensive than they already are.