Why Slow Growth Beats Fast Growth
I have to first say that I was surprised by this exercise. I have come to a conclusion that was not expected: slower growth can get you better returns than faster growth.
In this exercise, I initially thought that going 100% in the fastest growing stocks is the way to go. I’ve changed my view. As you will see below, growth doesn’t necessarily get you the best returns. It’s possible to beat everyone if you make bets on some very high growth speculative companies AND put all your money in them. This is really not the strategy I was looking for because the risk is too high.
When it comes to making money investing, you will beat most people by just showing up. What I mean by this is to invest early and often, stick with it, and buy quality investments that offer realistic, good rates of return.
To make a comparison, I used the following two investments:
Exciting Growth Investment (EGI):Dividend Yield: 1%, Earnings Growth: 11%.
Boring Value Investment (BVI): Dividend Yield: 7%, Earnings Growth: 5%.
A Simple Return Model
I’ve already discussed a simple dividend return model in a previous post. Here’s a quick summary.
Yearly Return = dividend yield + dividend growth rate.
This growth model is predicated on the idea that a company that increases its earnings will increase its dividends by a similar rate and that the share price will follow this growth over time.
So, for EGI and BVI the model indicates that they return the same amount over time: 12%/year. The model isn’t exact because due to compounding effects, the total return won’t be the same over different time frames (even assuming that the stocks perform exactly as the model suggests).
Higher growth equals a larger return. Look at the total return for these investments over a time frame of 5,10,15 years. In this chart below, we add up the total dividends collected to the appreciated stock price.
Note that it takes time for the growth to kick in. After 10 years the return goes into high gear. Now, lets consider the return if you compound the dividends along the way. This is what the compounded return looks like for the same time frames.
The slower growth investment (BVI) beats EGI until you get to about the 15th year. The reason? Compounding works by using elements of Growth and Time. Because BVI adds more money to the investment sooner, this has more time to grow than the realatively smaller dividends from EGI. So, Early Money is very important to compounding, too.
But, to be sure here, higher growth rates will eventually win out. The math is inescapable. Look at the same investments taken out to 30,35, and 40 years.
The results of this exercise give some clear investing advice. When you are investing you need to consider the time frame to determine how to get the best returns. If you are 10 years old, you can shoot for the fences to take advantage of the longest term growth rates. If your time horizon is only 20 years (say for future college expenses), it isn’t necessary to go for the highest growth. You can make a case that from a risk adjusted point of view, a higher dividend, slower growth approach will work best.
Some other conclusions:
- Compounding will get you higher returns. It’s especially important to compound your slow growth investments to with in the return race.
- It’s harder to find long term, high growth investments (double digits). But, you don’t necessarily need to work that hard to find them because carefully selected higher income, slower growth investments can get you similar big returns.
- Don’t risk giving up a ‘bird in the hand’ of a higher dividend for the uncertainty and promise of a higher growth investment. Every dividend you collect now is a return that can’t be lost and gets you closer to a good return.