The case for growth
We believe that growth forecasts reflect the human tendency to be overconfident and therefore do not fully account for mean reversion or instantaneously reflect new information. The overconfidence effect contributes to an overpricing of traditional growth companies and causes investors to underreact to new sources of unanticipated growth.
The theory behind our approach to growth investing
Within the Behavioural Finance Team at J.P. Morgan Asset Management, we believe investor decision making is shaped by behavioural biases that lead to a divergence between price and fair value. At its most basic level, investors tend to be overly optimistic about growth companies and overly pessimistic about value companies. These views are routed in the human tendency to be overconfident, where individuals have excessively rosy perceptions of their own abilities. The overconfidence effect has been described as “perhaps the most robust finding in the psychology of judgment” and can cause share prices to under-react to new information which conflicts with the prevailing judgment. The overconfidence effect contributes to an overpricing of traditional growth companies and causes investors to underreact to new sources of unanticipated growth.
A key manifestation of the overconfidence
effect is found in sell-side analyst forecasts. The evidence suggests that
analysts fail to fully account for the powerful mean reversion in growth rates,
implying that earnings forecasts for fast growing companies tend to be overly
optimistic. This is illustrated in Exhibit 1, where the red line shows the
lacklustre portfolio return from holding stocks with the best ex ante growth forecasts. Clearly the
forecasts were fully anticipated in share prices. The blue line, conversely,
shows the significant returns from holding those stocks with the highest ex post realised growth. The implication
is clear: analysts failed to correctly forecast the highest realised growth stocks. The real growth
stocks were unanticipated.
How do we exploit behavioural biases?
These behavioural inefficiencies can be exploited by building a portfolio with higher price and earnings momentum and higher quality than the market to access unanticipated growth. We believe companies that exhibit positive earnings and share price momentum will on average deliver growth ahead of analysts’ forecasts. This is because overconfident investors and analysts exhibit anchoring and herding behaviours that leads to trends in earnings forecasts and share prices. Strong upward revisions to forecasts are often an indicator that a stock will outperform going forward. In addition, stocks that have performed well over the last 12 months tend to continue to perform well and conversely stocks that have performed poorly tend to continue to underperform.
Additionally, we find that companies with high quality characteristics are more
likely to sustain periods of unanticipated growth. We define high quality as those companies that are profitable, have sustainable earnings and have a management team with strong capital discipline. We seek to avoid companies whose profit growth and margins are not sustainable. We expect management to be prudent, not profligate, with shareholder funds and are wary of companies that have a track record of issuing shares to make acquisitions, rather than financing growth through internally generated cash flow.
In particular we like to build a portfolio with higher profitability than the market. This reflects our belief that investors tend to place too much weight on earnings growth, which is not persistent, at the expense of profitability, which is persistent. Unlike growth, Return on Equity (ROE) reverts to the mean very slowly (Exhibits 2 and 3).
Our stock selection approach is entirely bottom-up and can result in differentiated sector allocations compared to traditional growth strategies. We believe that our focus on unanticipated growth differentiates us from many growth managers out there and this is evidenced by our peer group positioning with the JPM UK Equity Growth Fund now first quartile in its peer group over 2, 3, 4 and 5 years.*
Ben Stapley is the portfolio manager of the JPM UK Equity Growth Fund. Read more
 DeBondt and Thaler (1995). *Morningstar. Past performance is not necessarily a reliable indicator for current and future performance. Morningstar peer quartile ranking for JPM UK Equity Growth A Acc shares vs. IMA UK All Companies universe for periods to 31 January 2017. Morningstar™ rankings/universe: © Morningstar. All Rights Reserved.