Here is a secret formula that can help you to pick the growth stocks for your portfolio.
If value investing is difficult, investing in growth or glamour stocks is a bigger challenge. Why? The answer is simple. While investing in value stocks, we at-least, feel some degree of comfort since we know that we invest in stocks at rock-bottom valuation and the only major challenge is to avoid falling knives. As there is no high expectation built in the value stocks, the scope and impact of disappointment is much smaller and the residual pain may be limited.
However, the same is not true for growth stocks. Growth stocks trade with stratospheric valuation (as measured by P/B, P/E, EV/EBITDA etc.). So, inflated expectation is already built into the price. Any disappointment in terms of financial performance or a little hint of stagnating growth, can lead to severe pain in terms of huge decline in price leading to decline in fortunes of investors who have invested into such stocks at rich valuations. In the past, we have seen plenty of examples of how market euphoria built around sectors and stocks touted as “growth” (technology stocks (1999-2000) and real estate stocks (2007-2008)) have left many investors financially wounded. However, we also have several stories, where companies have maintained high growth for several decades and made fortunes of those investors who have stayed invested in such stocks.
So, the question is - do we have the MANTRA that helps us avoiding falling stars or the stocks facing serious “cliff risk” while picking growth stocks? The answer is YES! Partha Mohanram, in his 2005 paper, titled “Separating Winners from Losers among Low Book-to-Market Stocks using Financial Statement Analysis.” (Book-to-Market is inverse of widely used Market-to-Book metric) introduced G-score to answer this question. His work demonstrated that simply avoiding expensive stocks with low G-score can save investors from the perils of growth investing steering to a rewarding investment strategy. Let’s look at how we can calculate and use G-score in separating “Falling Stars” from “Sustainable Growth” stocks in three simple steps.
Step 1: Identify pricey stocks from the universe:
We choose our investment universe (say BSE 500 stocks) and sort stocks in the descending order of their Price-to-book value multiple (you can try alternative measures like P/E, EV/EBITDA or EV/EBIT as well) and then segregate them into five quintiles (20%), most expensive to the cheapest stocks.
Step 2: Calculate G-score for them:
G-score is calculated by using eight criteria divided into three groups: Profitability and Cashflow signals, Volatility/Riskiness of Growth, and Accounting Conservatism. A Stock gets 1 or 0 point for each criterion. Total of all points gives composite value of G-score in the range of 0 to 8. Let us learn technique to calculate G-score.
Profitability and Cashflow signalsReturn on Assets: 1 point if ROA is above industry median, 0 otherwise.
Cash Flow Return on Assets (CFROA): 1 point if CFROA is above industry median, 0 otherwise.
Accruals (Quality of earnings reporting): 1 point if accruals (as measured by difference between cash-flow from operations and net income) is below industry median, 0 otherwise.
Volatility of Growth/Riskiness of Growth signalsROA Variance: 1 point if ROA variability over the past five years is below industry median, 0 otherwise.
Sales growth variance: 1 point if Sales growth variability over the past five years is below industry median, 0 otherwise.
Accounting Conservatism signalsR&D Intensity: 1 point if ratio of R&D expenditure to Total Assets is above industry median, 0 otherwise.
Capital Expenditure Intensity: 1 point if ratio of Capital Expenditure to Total Assets is above industry median, 0 otherwise.
Advertising Intensity: 1 point if Advertising expenditure to Total Assets is above median, 0 otherwise.
Step 3: Use Mohanram’s G-score in separating sustainable growth stocks from falling stars
This step uses G-score calculated in step 2, helps separating quality growth stocks from the list of pricy stocks. The stocks with G-score of 6-8 are naturally potential winners and likely to sustain profitable growth in future, whereas stocks with scores of 0-2 have vulnerable growth stories. Of course, nothing is permanent and therefore the G-score must be calculated at least once every year.G-score is one of the best ways to identify falling stars from the pack of expensive stocks, and that makes the growth investing a highly rewarding investment strategy. Truly G-score is a secret sauce of successful growth investing!