Do Growth ETFs Actually Grow?

Growth doesn’t always get as much respect as longtime guru-favorite Value, and that may have something to do with hype-oriented rhetoric that often surrounds the former. But we need growth. Unless one can argue for growth, there’s pretty-much no point in being in stocks at all, as opposed to less-risky better yielding bonds. So Growth ETFs should be compelling – except when they aren’t.

The Role of Growth

Let’s start with the basics of stock pricing, the Dividend Discount Model. It calculates the ideal stock price as D (dividend) divided by the difference between R (required rate of return) and G (the expected growth rate); or P=D/(R-G). We can adapt this to valuations based on earnings, sales, book value, cash flow, etc. but no matter how many modifications we make, one thing never changes: G is always there and because it’s a negative number in the denominator of the fraction, the larger G is, the higher P goes all else being equal. Another way we can see this is to use earnings in lieu of dividend and algebraically reshuffle the equation to compute the formula for an ideal P/E, which is equal to 1/(R-G).

Although this is more theoretical than practical (obtaining credible workable estimates for G and R can be troublesome), this is important because of the way it illustrates the dynamics of stock pricing.

First, it confirms that the need for growth is real; very, very real. It’s not just something hucksters say to whip up excitement. In fact, the failure of Value ETFs to pay attention to G is an important reason why they don’t actually deliver value for their shareholders.

Second, it signals growth investors that higher growth rates alone may not cut it. They also have to pay attention to P, E and R. In fact, we can derive a theoretical formula for the growth rate needed to justify a stock price; G=R-(E/P).

A Real-World Problem

Obviously, the growth rate with which we need to concern ourselves is an expected growth rate; an assumption about the future. Obviously, as humans, we can’t know the future. The only information we have comes from the past.

So as much as we understand that past performance does not determine future outcomes, we have no choice to at least make ourselves aware of the past, if for no other reason than as a jumping off point for whatever else we might do as we attempt to make reasonable forecasts. And that’s pretty much what those who create the indexes tracked by Growth ETFs do:

Standard & Poor’s uses three factors to decide whether or not a stock belongs in one of its Growth Indexes and by extension in the ETFs built to track them: (i) three-year change in EPS over price per share, (ii) three-year rate of sales growth, and (iii) 12-month price change – presumably because it is seen as correlating with growth in sales, EPS, etc.

FTSE/Russell, whose Growth Indexes are used by some big-time ETFs including those sponsored by iShares and Vanguard, uses five factors three of which involve numbers from the past: (i) “Current Internal Growth Rate,” (ii) “Long-term historical EPS growth trend,” (iii) Long-term historical sales per share (SPS) growth trend.”

Morningstar, a more boutique-like firm when it comes to indexing and ETFs, goes full out when it comes to deconstructing past growth rates. It averages one-, two-, three- and four-year growth rates separately computed for earnings, revenues, cash flow and book value.

If you own a Growth ETF, there’s a strong probability your money is being invested on one of these indexers or another constructed in a very similar manner. FTSE/Russell and Morningstar add other factors based on analyst projections of the future. I’ll discuss those below. But first, let’s look more closely at the role of historic growth data, specifically, the extent to which the real world will allow us to get off the hook when we don’t ay attention to P, R and E.