The growth myth and its consequences

Growth companies are characterised by high revenue and profit growth rates, competitive advantages and a high level of innovative power. In recent decades, growth stocks have typically been found in the information technology, healthcare and consumer goods sectors, while companies with low revenue growth rates have often been seen in the energy, commodities or utilities sectors. Investors are often willing to pay a premium for growth companies due to the expectation of high future growth rates and the potential for higher returns. These shares are generally more volatile than is the case for companies with an unspectacular earnings performance, as future development is subject to great uncertainty.

Earnings growth rates of companies often overestimated

The average 1-year earnings growth of companies in the MSCI World Index realised since 1997 is 15.8%. The average earnings estimate of analysts is 7.2 percentage points higher, at 23%. At present, the difference between realised and estimated earnings growth is particularly great. While analysts have only slightly revised their estimates downwards, realised earnings growth fell sharply last year and is currently close to 0% (see graph).

Estimated and realized earnings growth of MSCI World Index companies

High growth rates fall faster than expected by investors

The chart below shows the number of companies that have achieved continuously realised earnings growth of more than 20% over a certain period of time. Since 1997, there have only been 28 companies that have achieved uninterrupted realised growth of more than 20% over a period of at least four years. One example is Apple, which achieved high growth rates, especially in the years 2004 to 2008, or Adobe in the years 2015 to 2019. Since 1997, no company included in the MSCI World Index has been able to maintain its high growth over more than six years. Analysts, on the other hand, are more optimistic about growth potential. Over the past 25 years, they anticipated that 398 companies would achieve earnings growth of more than 20% over a period of more than four years, while they believed 147 companies could do so for a period of more than six years.

Number of MSCI World Index companies with continued earnings growth >20% over different time periods (since 1997)

Why do analysts overestimate the growth potential of companies?

1. The anchor effect is a psychological phenomenon, which states that people assume an existing reference (anchor) when estimating a value. In addition to assessing the future development of the company, analysts base their growth estimates on earnings growth achieved in the past. If this is high, it is generally assumed that the growth rates will continue in the coming years. In reality, however, high growth rates fall significantly faster than investors anticipate.
2. The momentum effect: This herd behaviour leads to increased confidence in the company when profits are high and share prices are rising, and other investors also wanting to invest. Moreover, investors are afraid to miss a one-time opportunity. Investors generally want to invest in successful companies that have performed well in the past. Growth stocks are investors' favourites, which is reflected in above-average equity valuations, and they enjoy a strong presence in the media.
3. Too much profit growth expected in the long run: Investors tend to overestimate their own capabilities and judgement. This overestimation, together with the herd mentality, means that investors can be dazzled by the successes of companies in the past and project the company's positive development too far into the future.

Is investing in growth stocks worthwhile?

Empirical evidence since the 1930s shows that growth stocks generate lower returns than the overall market. Inexpensive value stocks with lower growth rates outperformed growth stocks. It is therefore not advisable to purchase a share only due to high growth rates in the past, as high growth rates generally only last for a short while and often fall faster than expected. When investing in growth stocks, a sound company analysis, in which the company strategy, development potential, valuation and industry environment are carefully assessed, is particularly important.