The role of growth in long term investment returns

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Journal Article
Journal of Applied Business Research, 2005, 21 (1), pp. 93 - 104
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Stocks with a high valuation compared to fundamental values imply a high growth rate, yet these stocks have typically under-performed in subsequent years supporting Lakonishok, Shleifer and Vishney's (1994) contrarian investment strategies. The precise definition of growth and subtle differences of measuring growth are explored in assessing the role of growth in long-term investment decisions and stock valuation. Results from a later period and with additional tests than employed by LSV indicate that growth is a primary valuation factor, and valuation measures such as E/P and B/M, are imperfect proxies for expected growth. Growth appears mean reverting, but investors do not seem able to discern changes in growth rates and this miss-specification of expected growth may help explain the superiority of value versus growth strategies. In addition, investors' naïve extrapolations of past growth provide explanatory power in future holding period returns.
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