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    Driehaus' Growth & Momentum Investing: A Roller-Coaster Ride

    by Wayne A. Thorp

    Momentum investors seek companies with rapidly growing earnings and prices to match. The hope is that continued earnings growth will attract additional investors who will continue to bid up the stock price.

    That investment philosophy, centered on earnings growth, underlies the approach used by Richard Driehaus, who was one of 25 money managers named in the year 2000 to the Barron’s All Century Team. He and his firm, Driehaus Capital Management, look for companies with strong and accelerating earnings growth. Their belief is that earnings growth is the primary driver of stock prices, as sustained earnings growth allows a company to increase cash flows and dividends. In his book “Investment Gurus” (Prentice Hall, 1999), Peter J. Tanous outlines Driehaus’ momentum strategy.

    The Driehaus Screen

    Based on Tanous’ book, AAII developed a Driehaus screen, which we have built into our Stock Investor Pro fundamental stock screening and research database program and track at AAII.com. The AAII Driehaus screen isolates small and mid-cap companies with:

    • Sufficient liquidity (daily trading volume);
    • Year-to-year increases in earnings per share from continuing operations;
    • Strong, positive earnings surprises; and
    • Short-term price strength on an absolute basis as well as relative to a company’s respective industry.

    The screening criteria used for this screen are detailed on page 29.

    Screen Performance

    Each month, AAII.com lists the companies passing the Driehaus screen and tracks the performance of these stocks in a hypothetical portfolio.

    Overall, the Driehaus approach has had mixed results compared to various broad market indexes. Figure 1 shows that the AAII Driehaus screen generated a cumulative return of 136.7% from the beginning of 1999 through the end of March 2007. While this significantly outperformed the large-cap S&P 500 index over the period, it lagged the performance of the S&P MidCap 400, which gained 153%. Likewise, the typical exchange-listed stock gained 262% during that time.

    Looking at the annual performance of the Driehaus methodology illustrates the highly volatile nature of this approach.

    First, the approach was up in only four of the eight years.

    Secondly, the Driehaus screen saw wild fluctuations in performance from one year to the next. In 1999, the methodology gained 107.4%, its best annual return. However, over the next three years, which included the bursting of the tech bubble, the attacks of 9/11, and a subsequent recession, the Driehaus screen lost a total of 61.8%.

    In the methodology’s four “up” years, it generated annualized returns of 54.8% for a total gain of over 474%. On the other hand, in the four “down” years, the screen lost 23.6% on average per year. Many investors are not willing to stomach such violent swings in their portfolio.

    Profile of Passing Companies

    We list the characteristics of the stocks currently meeting the Driehaus criteria in Table 1. Since momentum investors are more concerned with earnings growth and price momentum, they are willing to accept higher price multiples, such as price-earnings and price-to-book-value ratios. However, as compared to the typical exchange-listed stock, with a median price-earnings ratio of 19.8, the median price-earnings ratio for the Driehaus stocks of 20.7 is only slightly higher.

    Figure 1.
    Performance
    of Driehaus Screen
    CLICK ON IMAGE TO
    SEE FULL SIZE.

    While the AAII Driehaus screen looks for companies where year-to-year earnings growth has increased over the last three years, and earnings growth over the last four quarters (trailing 12 months) has been positive, we again find little difference between the median historical earnings growth for the current Driehaus companies (16.3%) and that of exchange-listed stocks (15.2%).

    Looking forward, the median estimated annualized growth in earnings per share for the current Driehaus companies is 20%, compared to 14.3% for exchange-listed stocks.

    Rapidly growing firms such as those sought by Driehaus tend to be small in nature, as measured by market capitalization. Looking at the companies currently passing the AAII Driehaus screen, we find that they have a median market cap of roughly $840 million, which places them at the upper end of the small-cap spectrum. In comparison, the median market capitalization for exchange-listed stocks is slightly over $500 million.

    Table 1. Driehaus Portfolio Characteristics
    Portfolio Characteristics (Median) Driehaus Screen Exchange-Listed Stocks
    Price-earnings ratio (X) 20.7 19.8
    Price-to-book-value ratio (X) 4 2.2
    EPS 5-yr. historical growth rate (%) 16.3 15.2
    EPS 3-5 yr. estimated growth rate (%) 20 14.3
    Latest quarterly EPS surprise (%) 27 2.2
    Market cap ($ million) 839.9 506.8
    Relative strength vs. S&P (%) 9.5 -4
    Monthly Observations
    Average no. of passing stocks 15  
    Highest no. of passing stocks 40  
    Lowest no. of passing stocks 1  
    Monthly turnover (%) 63.9  
    Data as of April 6, 2007.

    The current Driehaus stocks have outperformed the S&P 500 index by almost 10% over the last 52 weeks. In contrast, the typical exchange-listed stock has underperformed the S&P 500 by 4% over the same period.

    There are currently 18 companies satisfying the criteria of the AAII Driehaus screen. This is above the monthly average of 15 companies the approach has seen since the start of 1999. Over this period, the screen has generated at least one passing company each month and as many as 40 stocks in one month.

    Finally, given the strict earnings growth and price momentum requirements of the Driehaus methodology, it is probably not surprising that it has one of the highest monthly turnover rates among the screening strategies AAII tracks. In fact, its 63.9% monthly turnover rate is the highest among the growth strategies followed at AAII.com. This means that, in a given month, almost 64% of the stocks that pass the Driehaus screen did not pass the month before.

    Current Companies

    Strong, accelerating earnings growth serves as the cornerstone of the Driehaus philosophy.

    EPS Growth

    In order to pass the AAII Driehaus screen, a company must have increased the annual growth in earnings per share from continuing operations over each of the last three years. In addition, the growth in earnings per share from continuing operations over the last four quarters (trailing 12 months) must be positive.

    Looking at this value for the 18 companies currently passing the Driehaus screen (Table 2), we see that Denny’s Corporation leads all other companies with a stratospheric 512.5% growth rate over the last 12 months. The company, which owns, operates, and franchises Denny’s restaurants, earned $0.33 per share over the last four fiscal quarters, compared to a loss of $0.09 per share for the four quarters prior. However, for the quarter ending September 26, 2006, the company reported a gain on the disposition of assets of $39 million. Excluding this gain and the resulting income tax implications, the company would have broken even for the quarter. While the company would have still passed the screen, the earnings growth rate for the last 12 months would have dropped 156% (a loss of $0.09 to a gain of $0.05), which would have only placed the company in the middle of the pack of passing companies based on 12-month earnings growth.

    On-line diamond and jewelry retailer Blue Nile, Inc. just cleared the minimum hurdle with a 12-month earnings growth rate of 5.3%.

     

    Earnings Surprises

    Driehaus believes that one way to identify companies with strong earnings growth that are apt to continue that trend is by locating those with “significant” positive earnings surprises—when the company’s actual announced earnings beat the consensus analyst estimate. The AAII Driehaus screen deems a “significant” surprise to be 10% or greater.

    Among the current passing companies, Biolase Technology had the highest percentage earnings surprise of 500%. On March 14, 2007, the company announced earnings per share of $0.04, while the three analysts tracking it predicted a loss of $0.01 per share. EMS Technologies had the lowest percentage earnings surprise of 12.0%.

    Given that many rapidly growing small- and mid-cap companies are usually not yet profitable, it was a pleasant surprise to see that only two of the 18 passing companies reported negative earnings per share for the latest completed fiscal quarter.

    The number of analysts tracking a company is an important factor. Coverage by only one analyst limits the usefulness of an estimate; as the number of analysts covering a company increases, the consensus estimate becomes more credible. Therefore, the AAII Driehaus screen requires that at least three analysts offer estimates for the current fiscal quarter.

    Price Momentum

    Beyond earnings growth and positive earnings surprises, Driehaus also monitors price momentum. The AAII Driehaus screen looks for stocks with a gain in price over the last four weeks and we rank the companies in Table 2 in descending order by four-week price change. Ideally, you can catch a stock just as it enters a prolonged upward price move.

    Among the 18 companies currently passing the AAII Driehaus screen, DXP Enterprises has seen the largest price increase over the last four weeks at 30%. After the market close on March 15, 2007, the distributor of maintenance, repair, and operating products reported strong gains in quarterly earnings and revenues, and the following day DXP shares jumped almost 19%.

    Four companies saw a price increase of only 1% over the last four weeks.

    Another measure of momentum is relative price strength, which indicates how well a stock has performed compared to some benchmark—usually a market or industry index. Driehaus tries to invest in industry leaders, both in terms of earnings growth as well as price performance. Therefore, the AAII Driehaus criteria also require that a company have a 26-week relative strength value that is above the median relative strength for all the companies in the respective industry over the same period. DXP also has the highest 26-week relative strength figure among the passing companies, having outperformed the S&P 500 by 70% over the last 26 weeks. Meanwhile, Eclipsys Corporation has actually underperformed the S&P 500 by 1% over the last 26 weeks.

    Conclusion

    The momentum approach to stock selection developed by Richard Driehaus seeks to hit the “home run” that will provide above-normal returns. When investing in such potentially volatile stocks, it is very important to have a system in place that gets you out of a trade with only a minimal loss, while allowing the winners to ride until their momentum burns out. As the tech bubble of the late 1990s showed, momentum strategies can crash back to earth very quickly, with potentially devastating consequences for investors.

    As always, keep in mind that screening is only the first step in the investment process. The stocks passing this or any other screen do not represent a “recommended” or “buy” list. Before making any investment decisions, it is important to perform sufficient due diligence to identify those stocks that match your investing tolerances and constraints.

       What It Takes: Driehaus Screening Criteria
    • The year-to-year growth rate in earnings per share from continuing operations has increased over each of the last three fiscal years
    • Growth in earnings per share from continuing operations over the last 12 months has been positive
    • The latest quarterly earnings per share surprise (the percentage difference between the actual announced earnings and the consensus earnings estimate for the same period) is greater than or equal to 10%
    • At least three analysts have provided earnings estimates for the current fiscal quarter
    • The percentage change in stock price over the last four weeks is positive
    • The 26-week relative price strength is greater than or equal to the industry’s 26-week relative price strength
    • The market capitalization for the latest fiscal quarter is greater than $50 million and less than $3 billion
    • Those companies that trade as American depositary receipts (ADRs) are excluded
    • The average daily volume for the last 10 days is in the top 50% of all stocks


    Wayne A. Thorp, CFA, is financial analyst at AAII and editor of Computerized Investing.


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