The Problem with Growth Stocks

The problem with growth stocks is simple: they don’t grow as fast as investors expect them to.

A new study in the Journal of Finance finds that, contrary to conventional wisdom, growth stocks don’t grow substantially faster than value stocks. And because growth stocks therefore continually disappoint investor expectations, the long-term returns of investing in growth stocks are significantly worse than investing in value stocks.

“In the full sample period, growth and value stocks have approximately the same growth rates in dividends in buy-and-hold portfolios,” writes author Jason Chen. He found that since 1963, the earnings of value stocks actually grew faster than growth stocks, though the difference wasn’t always statistically significant.

In the paper’s key table, Chen sorts stocks into quintiles based on book-to-market ratios. He averages the dividends, assuming a $100 investment, and shows the growth rates of dividends from year 1 to year 10 after portfolio formation.

Figure 1: Average Real Dividends in Buy-and-Hold Portfolios for a $100 Investment

Source: Huafeng (Jason) Chen, “Do Cash Flows of Growth Stocks Really Grow Faster?” (Journal of Finance, Forthcoming)

The table shows that over the 10-year period, the average dividends of value stocks grew at a geometric average rate of 4.16% while growth stocks grew at 1.18%. Value stocks, in other words, grew dividends nearly 3% per year faster than growth stocks.

This evidence suggests that the intellectual premise of growth investing—paying higher prices to buy companies that will grow faster in the future—is flawed.

Don’t waste your precious investment dollars chasing dreams of future growth, especially not at a time when growth stock valuations are at record highs. Better to invest in value and be surprised when your portfolio’s cash flows grow faster than those of investors who paid up for growth that never materialized.