Growth investing is often considered the opposite of value investing. However, growth fundamentals influence how a company is valued. Today, I’m going to test how the long-term earning per share 5 year growth rate impacts stock returns.
The EPS 5-year growth rate I’m using for this backtest is the compound annual growth rate of earnings per share excluding extraordinary items and discontinued operations over the last 5 years. If the value for either the most recent year or the oldest year is zero or negative, that year is ignored. If a 5 year growth rate cannot be calculated, a 4 year growth rate was used instead. If less than 4 years are available, no growth rate is calculated.
Let’s take a look at a backtest of this EPS 5 year growth rate to see how it works. I used the data and backtesting tool provided by Portfolio123. The Portfolio123 backtesting eliminates the problem of survivorship bias by using point-in-time data and retaining data on stocks that have gone to zero. This backtest uses the same filtered universe of stocks as my recent Return on Equity Backtest. I’ve designed the filtering criteria for this backtest specifically for individual investors and with a focus on enhancing data quality. The filters include the following criteria:
- No OTC stocks. Stocks not traded on the New York Stock Exchange, NASDAQ, or American Stock Exchange markets are excluded. The quality of fundamental stock data for OTC can be somewhat lower and less timely that that for stocks traded on major exchanges.
- No ADRs. Fundamental data for foreign American Depositary Receipt can include errors due to currency exchange, different accounting standards, and share count.
- Liquidity test. The average daily total amount traded over the past 60 trading days must be larger than $100,000. This amount was selected so that a $1 million dollar portfolio could hold 100 positions and that each new $10,000 position would not exceed 10 percent of a day’s trading volume. The liquidity test also ensures that the backtest has reliable market price information for any of the stocks that are being tested.
- Market Cap > $50 million. Nano cap stocks are excluded to help improve data quality. This filter also ensures that positions in a modest sized portfolio never exceed one percent of shares outstanding or the available float for a company.
- Price > $1. True penny stocks are excluded due to various information issues and manipulation of these stocks.
- EPS5YCGr% != NA. This filter insures we are looking at stocks that actually have valid data for the EPS 5 year growth rate.
After these filters are applied, we are left with approximately 2,300 to 3,200 stocks. These stocks are then ranked by the criteria being tested; in this case, we are testing EPS 5 year growth rate. The lowest 20 percent of stocks ranked by EPS 5 year growth rate are placed in the first quintile and the next 20 percent in the second quintile and so forth until we have five portfolios of stocks. The portfolios are rebalanced every 12-months and compounded annually to more realistically replicate what an individual investor might be expected to do to avoid higher short-term capital gains tax and trading costs. The following charts displays the five quintile returns for the EPS 5 year growth rate, the backtest universe, and the S&P 500 Equal Weight Index. The first quintile includes the companies that had the lowest EPS 5 year growth rate and the 5th quintile includes the companies that had the highest EPS 5 year growth rate.
EPS, 5 Year Growth Rate Returns – 2000 – 2013
Summary of Results for the Earnings Per Share, 5 Year Growth Rate Backtest
This backtest for EPS 5 year growth rate reveals an unusual patter. The first quintile and 4th and 5th quintiles outperform, while the middle 2nd and 3rd quintiles underperform. This pattern might indicate that there might be some reversion to the mean occurring with long term earnings growth rates. Companies with the lowest EPS 5 year growth rates likely have negative sentiment on the Street and/or might be starting to pull out of a business cycle or at the beginnings of a turnaround cycle. Companies with the highest EPS 5 year growth rate might underperform the 4th quintile because they are likely loved by the Street and overvalued and/or their high earnings growth might be attracting a lot of new competition. Overall, this nonlinear trend in one year returns for stocks ranked by long-term earnings per share growth indicates that this fundamental is likely not a good factor to use on its own.
How have you used the Earnings Per Share, 5 year growth rate in your own investing process?