Two weeks ago, I delved into the first variable of AAII Growth Investing, AAII’s A+ Growth Grade, which helps investors find high-quality, sustainable growth stocks for the long term. Now, I explore the second variable, Partha Mohanram’s G-Score that uses a scoring system to identify growth stocks with the characteristics that lead to outperformance.
Growth investing refers to buying stocks attached to businesses with attractive characteristics that its rivals lack. These can include measurable factors such as growth rates in sales or earnings. They can also include more qualitative factors such as customer loyalty, a valuable brand or a competitive moat.
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. As a result, 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.”
However, most academic research suggests that investing in glamour stocks is a losing proposition.
On average, firms with high valuations determined by factors such as the price-to-book ratio or the price-earnings 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.
Stocks with high share prices compared to their book values tend to be glamour or growth companies that have attracted significant investor attention. As investors pile into a growth stock because of hype, strong relative price strength or high past or expected growth, its price deviates further from its underlying fundamental value. As with value investing, some growth stocks deserve their high valuations, while many others do not.
What Is Mohanram’s G-Score?
Partha Mohanram, CGA Ontario professor of financial accounting at the University of Toronto’s Rotman School of Management, developed a scoring system to help separate the winners from the losers among stocks trading with high price-to-book ratios. The grading system looks at company profitability and cash flow performance, adjusts for likely mistakes due to naive growth projections and considers the impact of conservative accounting policies to form a growth score, or G-Score.
Mohanram’s work identified fundamental factors that are useful when studying growth companies. Investors tend to naively extrapolate the current fundamentals of growth stocks or even ignore the implications of using conservative accounting to project future earnings. Mohanram refers to the signals of his grading system as “growth fundamental signals” since they measure the fundamental strength of these companies in a context appropriate for growth firms. Mohanram feels that stocks with stronger growth fundamentals stand a better chance of expanding earnings, avoiding exchange delisting and beating earnings forecasts. Most importantly, Mohanram uses several simple measures based solely on financial statement data that can separate winners from losers.
Defining the Universe
Mohanram’s work starts with a universe of high price-to-book stocks. Mohanram warns investors that these stocks do not perform well as a group, but it is possible to use fundamental analysis to help avoid the biggest losers and select the strongest candidates. Mohanram first limited his universe to the top 20% of stocks according to their price-to-book ratio.
We then excluded companies that are not exchange-listed. This filter ensures better liquidity (ability to buy and sell shares in a timely and orderly fashion) and higher reporting standards for financial statements. We also excluded companies in any real estate investment trust (REIT) industry and those based in China or Russia.
Rating High-Growth Stocks With the G-Score
Mohanram’s scoring system is an eight-point scale that helps to identify attractive growth stocks and avoid weak growth companies. Profitability, naive extrapolation and accounting conservatism are examined using popular ratios and basic financial statement data to create a “G-Score.” Mohanram found that high price-to-book stocks with higher G-Scores outperformed growth stocks with lower G-Scores.
The table below presents 11 attractive exchange-listed stocks of high price-to-book companies with a G-Score of 7 or 8, based on our interpretation of the G-Score components.
Select Passing Companies With Attractive G-Scores
Mohanram awarded up to three points for profitability: one point for return on assets (ROA) above the industry median, one point for a ratio of cash flow from operations to assets above the industry median and one point if cash flow from operations exceeds net income. Mohanram highlights academic research indicating that ratio analysis benefits from industry comparisons.
Mohanram defined return on assets as net income before extraordinary items for the fiscal year preceding the analysis divided by total assets at the beginning of the fiscal year. Our return on assets calculation deviates by using net income after extraordinary items in its calculation. Furthermore, we use trailing four-quarter figures for all of our calculations.
Return on assets examines the return generated by the assets of the firm. A high return implies the assets are productive and well-managed. If a company has a return on assets greater than the industry median, it is given one point, otherwise it is given a zero.
Mohanram reminds us that earnings may be less meaningful than cash flow for the early-stage growth companies that are likely to be found among the high price-to-book stocks. Operating cash flow is reported on the statement of cash flows and is designed to measure a company’s ability to generate cash from day-to-day operations as it provides goods and services to its customers. Operating cash flows consider factors such as cash from the collection of accounts receivable, the cash incurred to produce any goods or services, payments made to suppliers, labor costs, taxes and interest payments. Positive cash flow from operations implies that a firm was able to generate enough cash from continuing operations without the need for additional funds. Negative cash flow from operations indicates that additional cash inflows were required for day-to-day operations of the firm.
Mohanram also measures profitability by dividing the cash flow from operations by total assets. This is like the return on assets calculation but it is based upon cash flow instead of net income. A stock is awarded one growth point if the cash flow return on assets exceeds the firm’s industry median, otherwise a zero is recorded.
The final profitability variable examines the relationship between the earnings and cash flow. A growth point is awarded if cash from operations exceeds net income. The measure tries to avoid firms making accounting adjustments to boost earnings in the short run that may weaken long-term profitability.
Too often the market simply examines the past growth pattern of a company and expects it to continue into the future. Two companies with the same historical growth might have the same high valuation, but a company with more stable and predictable earnings and sales is more desirable and more likely to continue its growth. Mohanram feels that stability of earnings may help to distinguish between “firms with solid prospects and firms that are overvalued because of hype or glamour.”
Mohanram measures earnings variability as the variance of a firm’s return on assets in the past five years. A company is awarded one growth point if its variance in return on assets is below the industry median. A company must have five years of data to calculate the variance, or it is given a value of zero for this signal.
The second growth signal in this category relates to the stability of year-to-year growth. A firm that has stable growth is less likely to disappoint in terms of future growth. Mohanram examined the stability of sales growth to help overcome the issues of negative earnings, which many high price-to-book stocks may have. Sales growth may also be more persistent and predictable than earnings growth because it is less subject to accounting judgments.
Here, Mohanram compares the company variance of year-over-year sales growth to that of its industry median. Companies with lower variance than their industry median are awarded a growth point. A company must, again, have five years of growth data to calculate the variance, or it is given a value of zero for this signal.
The final three growth signals deal with company actions that might depress current earnings and book value but should result in greater growth and profitability down the line. Mohanram identified spending on research and development (R&D), capital expenditures (capex) and advertising as factors that may point to future sales and earnings expansion.
Conservatism in accounting standards forces companies to expense outlays for many R&D and advertising efforts even if they create valuable intangible assets that do not show up in a firm’s book value calculation.
A firm is awarded a growth point for R&D intensity if its ratio of R&D to assets is higher than its industry median.
The same is true for capex. One point is given for capex intensity if the firm’s ratio of capex to assets is higher than its industry median.
Lastly, a point is given if a company’s ratio of advertising expense to assets is higher than the industry median. It’s worth noting that many firms do not break out their advertising costs on their financial statements. This trend has accelerated over the years as more firms withhold this data from their competitors. Instead, they are lumped into their selling, general and administrative (SG&A) spending on the income statement.
What Is Growth Investing?
The AAII Growth Investing strategy grew out of AAII’s long-standing commitment of evidence-based investing—specifically, academic evidence.
There is a mountain of academic research that points to growth investing underperforming the overall market, and other factor-based strategies such as value investing, mainly because of the reversion-to-the-mean effect. Instead, AAII’s own backtesting shows that investing in stocks with “sweet spot” growth—not too high and not too low—yields market-beating results over the long term.
Furthermore, there is research into the ways of evaluating growth stocks and separating 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 shown to power future growth. The two variables are Mohanram’s G-Score and AAII A+ Growth Grade.
AAII Growth Investing will provide the analysis on sustainable growth companies as well as the strategy for maintaining a model growth portfolio.
The stocks meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to perform due diligence.
If you want an edge throughout this market volatility, become an AAII member.