INSIGHTS

On September 03, 2024

AAM Viewpoints — The Tortoise Wins

Source: Getty Images

One of Aesop’s most famous fables is the Tortoise and the Hare. This classic story between a slow-moving tortoise and a boastful hare has helped millions learn the lesson that “slow and steady wins the race.” Can this same lesson be applied to the world of investments?

We certainly think so, especially when it comes to investing in small cap growth stocks.

Rapid Growth vs Consistent Growth

If both the hare and the tortoise were small cap growth stocks, the former would be Rapid Growth Ralph and the latter would be Consistent Growth Carl. Many small cap investors are wooed by rapid earnings growth, and therefore, are likely to side with the arrogant and reckless hare, Rapid Growth Ralph. Others will side with Consistent Growth Carl and argue that patience and consistent growth may unlock better results over the long run. We happen to agree with the latter and here’s why.

Let’s explore how a strategy focused on stocks with stable earnings growth, lower volatility, and attractive valuations can help investors win the race.

High Sales Growth and Low Returns

High sales growth, while an important metric providing indications of a company’s health, does not always correlate to positive stock market performance. The following chart shows *20 sub-portfolios in a small-cap universe of stocks based on the 3-year trailing sales growth rate, since 1999. The bar at the left is the compound annual growth rate (CAGR) of the Russell 2000 Growth Index. Bucket #1 represents the lowest growth portfolio and Bucket #20 represents the highest growth portfolio.

Diagram 1

Source: Portfolio 123; Factset | Past performance is not indicative of future results. | *Segmented securities of the Russell 2000 by a factor (3-year trailing growth)

Two observations stand out:

1. The highest growth portfolio experienced the lowest returns, even lower than the lowest growth portfolio
2. The steady and consistent growth of Bucket 10 experienced the highest returns over time

Diagram 2

Source: Portfolio 123; Factset | Past performance is not indicative of future results.

As can be seen in Diagram 2, since 1999, the total return of this sample portfolio is -77.4% when the Russell 2000 Index returned 580.83%. We believe the message is clear…when it comes to growth, consistency should be an important consideration when buying small cap growth stocks.

The Low Volatility Anomaly

Aesop’s fable isn’t finished giving us investment lessons. The tortoise and the hare can also represent share price returns. Some stocks, like the hare, are volatile and move rapidly. Other stocks, like the tortoise, move more slowly. Conventional wisdom would tell us that volatile stocks are riskier and therefore they need to produce additional returns to compensate for that risk. Surprisingly, research shows the opposite to be true (See Diagram 5). The low volatility anomaly is an observation that stocks with less volatility tend to out-perform their higher volatility counterparts. While many explanations have been put forward to explain this anomaly, it most likely comes down to the demand for low-volatility investments by risk-conscious investors. This demand may be driven by the protection provided during periods of market drawdowns.

The following back test simulates holding 100 stocks which have the highest 1-year volatility and rebalances every 13 weeks starting in 1999. The compound annual growth rate is -8.3% which is 16% different than the benchmark.

Diagram 3

Source: Portfolio 123; Factset | Past performance is not indicative of future results.

On one hand, removing highly volatile stocks may enhance annual returns but it can do much more than that. Low volatility stocks have historically shown resiliency during times of market turmoil. Consider the below chart from January 2007 to March 2009 during the Global Financial Crisis.

Diagram 4

Source: Portfolio 123; Factset | Past performance is not indicative of future results.

The basket of 100 lower volatility small cap stocks experienced a much shallower drawdown than its benchmark — over 20% less! This effect is noted in wider studies dating back to at least 1985 in a universe of the 3,000 largest stocks.

Diagram 5

Source: AAM, FactSet, Axioma data | Past performance is not indicative of future results.

Conclusion

By combining the low volatility anomaly, with consistent growers and attractive valuations, investors may be able to produce turtle-like performance and potentially cross the finish line ahead of the sleeping hares!

CRN: 2024-0903-11952 R