Anomaly – Overpaying for Growth

Anomaly – Overpaying for Growth

How can investors overpay for growth? What risks does it cause? This week we tackle this question to help answer this important question.

Now, without a doubt, some stocks that trade at high Price to Earnings (PE) ratios may still be attractive if the company is able to increase earnings.

The problem is that reliably forecasting long-term earnings growth is a guessing game. In particular, beyond one year, there’s very little correlation between forecasts and actual earnings growth.

Also, consistent with the thesis that investors overpay for growth is the fact that asset growth, sales growth, and capital investment are ALL negatively correlated with future returns.

To some extent, that could be because corporate executives like to engage in “empire building”.

However, in most cases, it turns out that rapid sales growth isn’t bad…investors just simply overpay for them to the detriment of future returns.

The biggest thing at play here is a common behavioral bias at work – overconfidence.

Investors tend to overstate the likelihood that a company teetering on the verge of bankruptcy will be able to turn itself around, while also overstating that a high-flying company will be able to continue soaring.

What they really should be doing is focusing on companies that are already profitable and trade at a decent multiple of net asset value and earnings.