International equity investment provides investors with the opportunity to diversify their portfolios and gain exposure to foreign markets. However, research has shown that one of the most useful data points for equity investors is asset growth – the growth in the book value of a company’s assets. This article will examine the asset growth effect in international equity markets and the potential for systematic mispricing of high growth companies. With astute stock picking focused on asset growth rates, international equity investors may be able to generate significant outperformance.
Low asset growth stocks outperform high asset growth stocks in most markets
Academic research has consistently shown that low asset growth stocks outperform high asset growth stocks in the future on a risk-adjusted basis. This effect has been documented in 40 international equity markets by Watanabe, Xu, Yao, and Yu (2015). They find that across developed and emerging markets, stocks with high asset growth underperform stocks with low asset growth in the subsequent 3 to 5 years. This parallels earlier findings on the US market by Cooper, Gulen, and Schill (2008). This asset growth effect is attributable to two factors – the lower systematic risk of low asset growth companies, and the mispricing of high asset growth companies.
Mispricing of growth stocks drives the asset growth effect
The asset growth effect persists even after controlling for risk factors, suggesting some level of systematic mispricing is at play. High asset growth companies tend to be glamorized for their past earnings growth, leading to overly optimistic extrapolation of future growth. However, high asset growth is often not sustainable, resulting in subsequent underperformance. This dynamic introduces a component of overvaluation and future return reversal. Kam and Wei (2015) find evidence consistent with this mispricing narrative – the asset growth effect is more pronounced when future growth tends to reverse. International equity investors should be wary of overpaying for unsustainably high growth.
Focus on fundamentals and valuation discipline
Given the tendency for high asset growth companies to be overvalued, international equity investors should maintain strict valuation discipline. Rather than chasing flashy growth stories, build a portfolio of reasonably priced companies with solid fundamentals and assets. Monitor asset growth as a signal for future return potential. Stocks with low but steady asset growth may offer better risk-adjusted returns over the long run. Blending asset growth analysis with other factors like value, quality, and momentum can produce a robust process for international equity investing.
Tailor implementation to specific markets
The implementation of an asset growth strategy should be tailored to the characteristics of each international equity market. The effect is more pronounced in developed markets where stocks are more efficiently priced. Trading costs also vary across markets, impacting the viability of high turnover approaches. Investors must weigh the increased diversification benefits against implementation frictions in each market. Passive approaches tracking asset growth factors may be suitable in liquid, low-cost markets. In less efficient markets, higher potential for alpha likely warrants active stock picking.
In summary, the asset growth effect produces an actionable signal for international equity investors. A portfolio tilted towards low asset growth stocks, especially in developed markets, can potentially outperform over the long run. But beware of overpaying for unsustainably high growth stories.