Sustainable Growth Stocks and How to Find Them
by Jack Gilleland | October 20, 2022
Special note: This week, I am handing the keyboard over to my colleague Jack Gilleland. Jack explains why the best growth stocks are not the glamour ones that tend to make headlines but rather those with growth rates in the “Goldilocks” zone.
—Charles Rotblut, CFA
The term “growth” when categorizing stocks is associated with identifying companies that will potentially have price appreciation at a rate considerably above the market’s average rate of return.
Growth stocks tend to hold promising positions in emerging industries or niches that feature long runways for expansion. Because of this desirable potential, and the unusually strong success the business has had in recent years, a growth stock is often priced at a premium that reflects the optimism investors have in the company. 
The simplest way to know whether you’re looking at a growth stock is if its valuation—such as the price-to-book-value (P/B) ratio or price-earnings (P/E) ratio—is high relative to the broader market and its industry peers. These high-valuation stocks are often referred to as “glamour stocks.”
On average, firms with high valuations determined by factors such as the price-earnings ratio or price-to-book ratio underperform the market over the long term. While the market does a good job of valuing securities in the long run, in the short term it can overreact and push prices away from their true value.
Growth investing is one of a multitude of strategies that an investor can utilize to achieve their financial goals. The main objective is to find companies with sustainable long-term growth factors in order to avoid the glamour stocks. One foundation of the new AAII Growth Investing strategy is the G-Score, a grading system developed by Partha Mohanram—a professor at the University of Toronto’s Rotman School of Management—that scores stocks based on profitability, cash flow factors and accounting policies.
On November 1, 2022, utilizing the Mohanram G-Score and AAII’s new A+ Growth Grade, AAII will release a Growth Investing newsletter that applies these concepts to a 20-stock model portfolio and includes a stock ideas list and weekly commentary.
AAII Growth Investing
The AAII Growth Investing strategy grew out of AAII’s long-standing commitment to evidence-based investing—specifically, academic evidence.
Historically when market segments are seeing abnormally high profitability, they attract competition, leading to an eventual decrease in profitability. This decrease in profitability returns growth back to average levels, causing the underlying stock to decline. This is called the reversion-to-the-mean effect. The theory is that abnormally high growth—in comparison to a stock’s long-term average or the average of the entire market—must eventually return to the average.
AAII’s own backtesting shows that investing in stocks within the “Goldilocks” zone of growth—not too high and not too low—leads to market-beating results over the long term.
Furthermore, there is research on ways to evaluate growth stocks and separate the winners from the losers based on financial statement analysis.
The AAII Growth Investing strategy rests at the intersection of those two elements: identifying companies with a history of consistent and sustainable sales growth and cash generation AND with fundamental characteristics that have been shown to power future growth.
These elements are the core composition of the G-Score and the A+ Growth Grade. The goal is to identify companies with quality, sustainable growth. We know that historically, growth underperforms value; however, following an evidence-based approach opens the potential to identify sustainable growth stocks that you can feel confident in, especially if you’re a long-term investor.
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Strong Estimated Growth Fails to Lead to Strong Returns
Results of backtesting the A+ Growth Grade with a projected earnings growth rate component. -
Uncovering Consistent & Sustainable Growth With the Revised Growth Grade
Through testing, we found evidence that we could build a better grade to help members identify promising growth stocks and the key components that make them so. -
Segmenting Growth Stocks With the G-Score
An eight-point scale based on fundamental factors helps to identify attractive growth stocks and avoid weak growth companies.
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AAII Sentiment Survey
Both optimism and pessimism about the short-term direction of the stock market rose in the latest AAII Sentiment Survey. All three readings—bullish, neutral and bearish sentiment—are at unusual levels, as is the bull-bear spread.
Bullish sentiment, expectations that stock prices will rise over the next six months, rebounded by 2.2 percentage points to 22.6%. Optimism is below its historical average of 38.0% for the 48th consecutive week. It is also unusually low for the eighth consecutive week and the 31st time in 42 weeks. The breakpoint between typical and unusually low readings is currently 27.6%.
Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, pulled back by 2.5 percentage points to 21.2%. Neutral sentiment is below its historical average of 31.5% for the 24th time in 26 weeks. It is also unusually low for the fourth time in five weeks. The breakpoint between typical and unusually low readings is 23.1%.
Bearish sentiment, expectations that stock prices will fall over the next six months, increased 0.3 percentage points to 56.2%. Pessimism is above its historical average of 30.5% for the 47th time out of the past 48 weeks and is at an unusually high level for the 32nd time out of the last 40 weeks. The breakpoint between typical and unusually high readings is currently 40.7%.
The bull-bear spread (bullish minus bearish sentiment) is –33.6% and is unusually low for the 31st time in 39 weeks. This week’s reading ranks among the 30 most negative in the survey’s history. The breakpoint between typical and unusually low readings is currently –11.3%.
Historically, the S&P 500 index has gone on to realize above-average and above-median returns during the six- and 12-month periods following unusually low readings for bullish sentiment and the bull-bear spread. Unusually high bearish sentiment readings historically have also been followed by above-average and above-median six-month returns in the S&P 500. The S&P 500 has underperformed following periods of below-average neutral sentiment, though the link is weaker.
Continued volatility in the major stock indexes along with inflation, corporate earnings and increased chatter about the possibility of a recession are all likely weighing on individual investors’ short-term expectations for the stock market. Also influencing sentiment are monetary policy, politics and the ongoing invasion of Ukraine by Russia.
Bullish: 22.6%, up 2.2 points
Neutral: 21.2%, down 2.5 points
Bearish: 56.2%, up 0.3 points
Bullish: 38.0%
Neutral: 31.5%
Bearish: 30.5%
See more Sentiment Survey results.
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Discussion
John L from NJ posted over 3 years ago:
The AAII is creating a new growth investing newsletter using back testing and Partha Mohanram's grading system. I assume the implied promise is that the AAII will provide information that will lead to market beating results that more than justify the cost of the subscription. The AAII is certain to profit (as a non profit - bigger salaries and perks for existing staff). Subscribers only profit if their advice beats the market. The unspoken downside is that the new growth investing newsletter's advice could fall short of the market's returns. We know that achieving market beating returns is difficult from the data provided by SPIVA. Over the long term 90% of active mutual funds fail to beat their index. Because this newsletter doesn't have a track record; the AAII should publish the track records for all existing AAII newsletters. No point being modest. If the AAII has market beating expertise; their records will prove it.
Barry C Johnson from TX posted over 3 years ago:
I don’t want to be a “Debbie Downer” and take away the punch bowl before the party gets rocking, but I suspect that this plan to produce market-beating returns is counterintuitive to two latent and inherent market mechanisms that will reduce its potential for success. One short term and one long term. Short-term, the weak version of Fama’s efficient market hypothesis predicts that any insights gained though fundamental analysis of public company data or “mined” through backtesting of publicly available past performance data is already known by other market participants (such as anyone who read Mohanram’s articles since they were published first in 1999 and last in 2021) who have already acted on it before you can act on it and, as a result, the price will increase/decrease erasing any planned profits you expect before you can act it. Long-term, Galton’s Regression to the Mean concept predicts that, in any series of random events, like a market, any extraordinary event, like a perceived market anomaly, such as “growth” or “value” or “quality,” that proports to increases a stock’s price is most likely, purely by chance, followed by an ordinary event closer to average performance, better known as a lower price. Here’s a preview of the power of these forces. After I read Wayne’s earlier article, I created a Watch List of the 8 stocks rated 8 in Wayne’ article. As of YESTERDAY, ALL 8 have increased in price between 3% to 9%. I guess some other AAII folks who read Wayne’s article got to the punch bowl first. QED. That makes us late comers the reversion to the mean folks. However, I do not doubt the LONG long-term efficacy of Wayne’s analysis to produce results. Jeremy Siegel’s “Stocks for the Long Run” (2016) showed that the market as a whole has a long-term trend of appreciating about 5% per year. I know of no data on the appreciation of a subset of highly correlated stocks like the Mohanram’s G SCORE stocks.
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