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...The primary motivation for the study springs from the documented differential preference among investors for value and growth stocks. Despite evidence that value stocks tend to outperform growth stocks, investors retain strong interest in growth stocks. Yet in examining the performance of Business Week's (BW), smaller capitalization companies (called "Hot Growth Companies") with respect to the overall financial market, Bauman et al. [2002] found positive excess returns in the pre-publication period but negative excess returns in the post-publication period. A limitation of their study is that their analyses relied on only three criteria: sales, BW rank and return on capital, which do not represent completely a firm's financial health. I replicate Bauman et al. 's study but use a more robust and representative variable set to test the mean reversal hypothesis--Forbes' financial criteria--and I focus on six variables. In the current study, I look at 4,200 companies listed in Forbes from 1980 to 2000. The results of the expanded study substantiate Bauman et al.'s [2002] study showing that there are positive excess returns in the pre-publication period, but negative excess returns in the post-publication period. An expanded future study will look at five additional variables to see if they make a significant difference on the effects of the returns of small growth stocks. (JEL G20, G30, MOO)
Introduction
I seek to ascertain if the investment performance of Forbes' firms offers good investment opportunities. Expanding the research related to growth and value-investing, styles can provide practical investment insights to investors that follow such business magazine trends. Studying Forbes stocks can provide comparative performance with BW firms. The study will, thus, corroborate or refute Bauman et al.'s [2002] hypothesized behavior of small cap stocks. Including alternate definitions of income calculation provides additional evidence of their explanatory power for small cap firms.
Motivation and Project Description
Investors often support companies and their corporate managements because these companies usually exhibit recent financially strong performance such as high past growth in corporate sales and profits and high rates of return on capital. However, Clayman [1987] challenged the notion that good companies make good investments after examining the investment performance of a sample of companies featured in Peters and Waterman's [1982] In Search of Excellence, who, in turn, identify financial criteria that distinguish excellent from poor companies. Clayman [1987] compared the subsequent investment performance of predominately large cap companies that were judged to be excellent with a sample of companies considered to be financially mediocre, finding that the mediocre companies' stocks not only outperformed a stock market index by a wide margin but also outperformed the so-called excellent companies as well. Clayman [1987] concluded that:
The 'good' companies underperform because the market overestimates their future growth and future return on equity and, as a result, (overvalues) the stocks ... the converse is true of 'poor' companies.
Bannister [1990] empirically reconfirmed these results. Solt and Statman [1989] and Shefrin and Statman [1995] also found inverse relationships between companies with excellent reputations and high past growth rates relative to their subsequent stock price performance. Many studies have also shown that the stocks of companies with high past growth rates have underperformed value stocks that had low price-earnings ratios or low past growth rates [Graham and Dodd, 1934; Basu 1977; Fama and French, 1992; Haugen, 1995; Bauman and Miller, 1997]. Bauman and Miller [1997] found that securities research analysts tend to overestimate the earnings ratios of growth stocks as compared to value stocks with low price-earnings ratios. They also found that corporate growth rates experienced a mean reversion tendency, in which high past growth rates tended to decrease while low rates tended to increase over time.
Cook and Rozeff [1984] and Bauman and Miller [1997] found that apparently overlooked small cap stocks often perform differently than large cap stocks. In this context, the purpose of this study is to examine the investment performance of small growth companies.
Data and Methodology
Forbes' ["Hot Shots ..." 1980-2000] annual study of 200 growth companies provides an excellent data source to test whether small growth stocks make superior investments. Using 21 years of Forbes' selections to test my hypothesis yielded a 4,200-company data set. While Forbes says that its list of companies possesses outstanding historical performance, it stresses the potential risks of investing in small, high-growth stocks and the desirability of such companies as investments. (1) Unlike other studies that distinguish growth stocks from value stocks using only one or two types of financial variables, the Forbes' model relies on three such financial criteria.
To test if small growth stocks make superior investments, I will analyze Forbes' annual studies, "Up and Comers" or "Best 200 Small Companies in America," from 1980 to 2000, rating small company growth stocks using such financial criteria as historical performance and future potential capital appreciation. Forbes criteria include: (1) annual sales below $100 million; (2) last five years' average return on equity to exceed 15%; and (3) book value exceeding its debt. Forbes discloses one and five-year returns on equity, five-year Earnings Per Share (EPS) growth rate, net sales, net income, net profit margin, book value per share, debt as a percentage of book value, recent stock price, EPS for the last five months, and Price Earnings (P/E) ratio. Selecting stocks annually from a universe of approximately 7,000 to 10,000 publicly traded corporations in Standard and Poor's COMPUSTAT database, Forbes requires that such companies belong in the industrials category, have corporate sales between $10 and $150 million with a current market value greater than $1 million, and have stock actively rated at over $5.
Forbes assigns each selected company a composite rank equal to the sum of 0.5 times its rank based on return on total capital, plus 0.25 times its rank based on growth rate in net income, plus 0.25 times its rank based on growth rate in net sales. It defines return on capital as earnings plus minority interest and tax-adjusted interest expense, divided by total debt plus equity, for the latest available fiscal year. The growth rate in sales and income is the least-squares growth rate for the most recent three fiscal years. If results in the first year are negative, then the growth rate is based on the second and third years. Income is measured as net income from continuing operations before gains or losses from...
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