Why you should be wary of fast-growing companies

(MoneyWatch) We recently discussed why you shouldn't load up on Apple and Facebook. In that spirit, the following is another important reminder about why you should be wary of investing in companies whose earnings are growing much faster than the overall economy.

One of the most fundamental principles of economics is that profitability is "mean-reverting." In a free market, capitalist society, that means when profits are "abnormally" high (far in excess of the cost of capital), more capital gets allocated to that industry, product, or service. The result is that supply and competition increase, and profits revert to the mean (approach the cost of capital). This eventually eliminates the "abnormal" profits. When profits are below normal, capital gets allocated away from that industry. Thus, supply and competition is reduced, and normal profitability is restored.

Despite the logic, there's a large body of evidence that suggests that investors and stock market analysts alike ignore this principle. In their study "Forecasting Profitability and Earnings," economist Eugene Fama and finance professor Ken French tested whether the theory of profitability reverting to the mean stood up to the historical data. Their conclusions:

• There's a strong tendency for profits to revert to the mean
• Reversion to the mean is strongest when profits are highest (greatest incentive for competition to enter) and lowest (greatest incentive to leave an industry and reallocate assets, thereby reducing competition and restoring profits)
• Abnormally low earnings tend to revert even faster than abnormally high profits
• Reversion to the mean occurs at a rate of about 40 percent per year (!)
  
• Real-world forecasts tend to underestimate the speed at which reversion to the mean in profitability occurs

Reversion to the mean of abnormal profits occurring faster than the market anticipates provides a behavioral explanation for why growth stocks have produced lower returns than value stocks, despite their better earnings performance. The market appears to overestimate the amount of time that growth companies can generate abnormal profits. Ultimately, earnings expectations aren't met, and this gets reflected in lower equity returns. The reverse is true of value companies. The market appears to overestimate the time it takes for abnormally low profits to revert to the mean. Ultimately, earnings expectations are exceeded, and this is reflected in higher returns.

Another study by Harvard professors John Lintner and Robert Glauber found similar evidence of this trend. They asked the question: What percentage of the difference in growth rates in one period was explained by the difference in growth rates from the preceding period? Their conclusion: The persistency of earnings growth rates was close to zero. The rankings from one period to the next were virtually independent of one another. In other words, the past has been a poor predictor when it comes to forecasting growth rates and abnormal profits tend to revert to the mean.

Another study sheds light on just how quickly profits tend to revert to the mean. The study broke U.S. stocks into four categories:

• Lowest earnings-to-price ratio (growth)
• Low E/P
• High E/P
• Highest E/P (value)

The authors then examined the rates of growth of earnings of both value and growth companies after the portfolios were formed. They concluded that while growth companies continued to grow faster than value companies, there was a clear and persistent reversion to the mean -- after about five to six years, earnings growth rates had reverted, virtually eliminating any difference.

The problem for investors is that analysts' forecasts and market prices reflect the projection that earnings growth rates for both growth and value companies won't revert to the mean in that short a time span. Thus, growth investors are ultimately disappointed and value investors ultimately surprised. This helps explain the greater historical returns to value investors.

The following is another example of just how difficult it is to maintain a very high growth of earnings rate. According to researchers at boutique investment bank Sanford C. Bernstein & Co., over the past half century (ending in 2000) only 10 percent of companies in the S&P 500 increased their earnings at an average rate of at least 20 percent a year for five years running. Only 3 percent have raised earnings at least 20 percent annually for a decade. And none had sustained 20 percent earnings growth for 15 years or more. In the long run, it's just not possible for stock prices to rise faster than the earnings of the companies they represent.

Another study on the ability of companies to maintain high levels of earnings growth, "The Level of Persistence of Growth Rates," provided both compelling evidence and valuable insights for investors. The authors analyzed long-term growth rates in earnings across broad cross sections of stocks. The following is a summary of their findings:

• While some firms have grown at high rates historically, they're relatively rare instances and about what we would randomly expect. Specifically, only four firms a year achieved annual growth rates above the median for a full 10-year run. This was just 0.2 percent of all firms and just 0.1 percent more than randomly expected. Only 3.6 percent achieved that goal for just five years. Randomly we would expect 3.1 percent to do so. This was true even in fast-growing industries like technology and pharmaceuticals.
• There was no persistence in long-term profit growth rates beyond chance.
• Valuation ratios had little predictive ability in terms of future growth rates. They had little ability to differentiate between firms with high or low future growth rates.

The problem for investors is that forecasts of high-growth rates in earnings lead to high P/E ratios. When those high-growth rates aren't realized, investors are smacked with a double whammy. Not only do earnings fail to achieve the targets, but the failure to achieve the anticipated growth rate leads to a collapse in the P/E ratio and a geometric fall in price.

The bottom line, as the authors of one study concluded: "The chances of being able to identify the next Microsoft (MSFT) are about the same as the odds of winning the lottery."

Image courtesy of Flickr user 401K