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Mehdi Alighanbari

Mehdi Alighanbari
Executive Director, MSCI Research

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Growth Without the Side Effects

  • Some of the higher valuations associated with growth stocks may be unavoidable and a characteristic of paying for the growth potential of certain companies.
  • In addition to higher valuations, growth stocks tended to have other characteristics, such as high volatility, low yield and low quality, that may negatively impact the performance of a growth portfolio.
  • By controlling unintended exposures, we extend the concept of growth at a reasonable price (GARP) to seek growth at a reasonable level of volatility, yield and quality.

Growth stocks have often been identified by their high rate of historical and/or expected growth, measured in terms of earnings and sales. But they have also shared other similarities. One well-documented characteristic of growth stocks has been their high valuations, which is why sometimes growth is considered the opposite of value. This is also the reason that many traditional value/growth style indexes were designed based on this division.

 

The Indexes According to GARP

Valuation metrics often do not account for the growth potential of a company. Indeed, higher valuations of growth stocks may be justified as the price to pay for growth. The key is not to overpay for growth and potentially suffer losses in the long run.

The idea behind growth at a reasonable price (GARP), a concept often used by growth investors, is exactly that — to avoid paying too much for the potential growth of a stock. Using growth as a measure of value, sometimes used by investors such as Warren Buffet, also stems from the same view.

The GARP idea can be extended to the portfolio level by controlling the value exposure when constructing a growth-factor index. Here the objective would be that the long-term premium from growth exposure would not be eroded by the unintended and incidental impact of negative exposure to the value factor.

To show this, we first simulate a simple growth index with no control on other factors. The index is constructed by selecting the stocks with the highest growth scores1 from the MSCI World Index and then tilting the market-cap weight based on the growth score. The exhibit below shows the exposure of this simple growth index to different style factors.2

Not surprisingly, there was significant and persistent exposure to the growth factor. Also, unsurprisingly, the index’s value exposure was consistently negative over the period of analysis from June 1999 through June 2020. The negative exposure to the value factor could have had a negative impact on the performance of this simple growth index.

 

Simple Growth Index: No Controls on Exposures to Other Factors

 

It’s Not Just Value

In addition to value, the index also showed significant, persistent and unintended negative exposure to yield over time. The exposure to low volatility and quality were negative, on average. Given that these factors have historically earned positive excess returns over long time periods, unintended or incidental negative exposure to them could have had a negative impact on performance of the index.3

The question then becomes, why control only for value? Why not expand the GARP concept to control volatility, yield and quality? And, how could we go about modelling such controls?

For a fundamental manager with a growth focus, the approach may be to investigate each growth stock individually and ensure the growth levels justify the exposure to other factors (value, volatility, quality, etc.).

For a broad and diversified growth-factor index, the exposures could be controlled at the index level. To demonstrate, we used the MSCI World Growth Target Index where exposures to unintended factors are controlled. Using a fundamental factor model such as MSCI GEMLT enables us to measure and maximize exposure to the growth factor while controlling for unintended factor exposures.4 Staying with value as an example, a constraint is imposed on the overall valuation of the index to ensure it is within an acceptable range (in-line with the broad market in this simulation). This explicitly limits the effect of the value factor on the performance of this controlled growth-factor index both in the short and long term.

The exhibit below shows exposure of the MSCI World Growth Target Index to the eight factors. With the controls in place, the index still showed persistent and significant exposure to the growth factor, while negative exposures to other premium factors were minimized.5 This can be interpreted as achieving growth at a reasonable price, as well as reasonable volatility, yield and quality at the index level.

 

MSCI World Growth Target Index: Controlled Exposures to Other Factors

 

Effect of Controlling Unintended Factor Exposures on Performance

To illustrate the effects of controlling negative exposure to premium factors, the exhibit below shows the contribution of the eight factor families to the returns of the two growth indexes discussed above (the simple simulated growth index and the controlled MSCI World Growth Target Index) from June 1999 through June 2020.

Both indexes benefited from positive exposure to the growth factor, and the momentum factor also contributed positively to the overall performance of both. In the simple growth index, the negative exposures to value, low volatility, yield and quality resulted in these factors impairing index performance. In this case, the negative contribution of these factors was much greater than the positive contribution of the growth factor. When these unintended exposures were controlled, however, it helped eliminate the negative impact.

 

Factor Return Attribution of Simple Growth vs. the MSCI World Growth Target Index

Data from June 1999 through June 2020

While the growth factor has historically shown a long-term premium, capturing the premium within a systematic factor index has not been as straightforward as other risk-premia factors such as value and momentum. Simple ranking strategies that have worked for other factors failed to efficiently capture the growth premium. In our analysis, we demonstrated that when we controlled exposure to other factors, as illustrated with the MSCI World Growth Target Index, we were able to capture the growth premium without it being lost to unintended factor exposures.

 

 

1To measure growth, we used the growth factor exposures (scores) from the Global Total Market Equity Model for Long-Term Investors. Morozov, A., Minovitsky, S., Wang, J., and Yao, J. 2015. “Barra Global Total Market Equity Model for Long-Term Investors — Empirical notes.” MSCI Model Insight.

2Please see Bonne, G., Roisenberg, L., Aylur Subramanian, R., and Melas, D. 2018. “Introducing MSCI FaCS: A new factor classification system for equity portfolios.” MSCI Research Insight.

3Morozov, A., Minovitsky, S., Wang, J., and Yao, J. 2015. “Barra Global Total Market Equity Model for Long-Term Investors — Empirical notes.” MSCI Model Insight.

4Alighanbari, M., Melas, D., and Sharma, S. 2019. “The growth-factor premium: Seeking a systematic approach for capturing it.” MSCI Research Insight.

5Liquidity is not considered a premium factor; therefore, its exposure is not tightly constrained in this index simulation.

 

 

Further Reading

Capturing the Growth Factor Premia

The growth-factor premium: Seeking a systematic approach for capturing it

Growth’s outperformance was and wasn’t an anomaly

Introducing MSCI FaCS white paper

Regulation