MW Looking for the stock market's next big winners? Just look for these three numbers.

By Brett Arends

While investors today seem gripped by a mania for growth stocks, they are really just gripped by momentum. They are buying assets that have already gone up in the hope that they will keep going up.

If you're looking for the best growth stocks for your retirement portfolio, pay no attention to the stocks you read about online or even the stocks that dominate the big growth funds such as the Invesco QQQ Trust exchange-traded fund QQQ or the Vanguard Growth ETF VUG.

And, maybe more surprisingly, pay no attention to the market value, or to valuation multiples such as price/earnings ratios or price/earnings/growth ratios, either.

Instead just look for three things: The growth over the past five years in research and development expenditures, revenues per share and earnings per share. And especially the first two.

So report legendary Wall Street guru Rob Arnott and his team at investment advisory firm Research Affiliates in groundbreaking research (see here and here).

And it could hardly be more timely, coming as investors' mania for growth stocks hits new peaks.

Arnott's team found that growth stocks picked on the basis of these three measures have beaten the overall stock market, as well as traditional growth-stock indexes, by a country mile going back at least to 1970, where they began their research.

Arnott tells me he suspects the outperformance goes back much further, although confirmation will have to wait for further historical analysis.

"Human nature doesn't change a lot from generation to generation," Arnott says.

Since the start of the 1970s, investing in stocks based solely on five-year sales growth has beaten the overall stock-market index by an average of 15% a year, while investing based on R&D growth has beaten by an average of 20% a year, Research Affiliates has found. This has been true despite - or perhaps because of - the fact that this strategy has ignored traditional growth-stock indexes and issues of valuation.

In a nutshell, it involves buying the stocks of companies with the strongest growth, regardless of valuation.

Arnott, a self-described value investor who prefers to invest in stocks based upon traditional valuation metrics such as price/earnings ratios, admits he began this project as a skeptic and was surprised at how well this alternative approach worked.

To put this into numbers, if you had, on the last day of 1969, invested $100 in the Russell 1000 index of the most valuable 1,000 U.S. companies and then just left the money there, compounding away, by the end of 2024 you'd have had about $25,500 - an average annual rate of return of 10.6%, according to Research Affiliates data. (This illustration ignores the real-world costs of taxes and fees).

If you'd invested that money in the Russell 1000 growth index, which invests in the supposed growth half of the index, you'd have ended up with $26,800, they reckon. That's an average annual return of 10.7%.

But if, instead, you'd invested consistently in the companies that had the biggest increases of revenues per share over the previous five years, ignoring everything else, you'd have ended up with more than twice as much at the end: $56,200, thanks to an average annual return of 12.2% a year. Such are the effects of compounding over such a long time.

And if you'd invested based solely on the companies' five-year growth in R&D, your long-term gains would have been even more dramatic. You'd have ended up with just over $75,000, or about three times as much as you'd have earned from the market indexes. Average annual return: 12.8%.

Research Affiliates' strategy involves first screening stocks based on the percentage growth of these measures, and then weighting investments based on the size of the growth. In other words, your biggest investment wouldn't be in the company with the highest market value, or the company with the fastest growth in sales or R&D, but rather the company with the biggest dollar-value rise in sales or R&D over the past five years.

There are multiple reasons this strategy has worked so well, Arnott argues. Among them: The obviously flawed logic at the heart of traditional indexes, which are mostly designed by and for the fund-management industry rather than its clients. Traditional indexes are capitalization-weighted, meaning that they give more weight to companies that are more highly valued by the stock market, regardless of the reason. This rewards market popularity over anything else. It means, in effect, that you end up buying stocks simply because other people are buying them.

What could possibly go wrong?

The strategy also avoids investing in companies that are growing slowly but whose stocks have ended up in growth portfolios by default, because they are expensive in relation to earnings or net assets. That's one of the issues with simplistic indexes that divide the stock market cleanly into (expensive) "growth" stocks and (cheap) "value" stocks.

Calling a stock a growth stock simply because it is expensive is "idiotic," as Arnott points out.

Research Affiliates' strategy also works because it ignores two of Wall Street's more costly obsessions: short-term news like quarterly earnings, and analysts' forecasts, which are characteristically overoptimistic. Instead it focuses on reality - actual growth - and looks back over five years.

There are, of course, no guarantees this strategy will work as well - or indeed at all - in the future. There again, that's true of all investment strategies.

While investors today seem gripped by a mania for growth stocks, they are really just gripped by momentum. They are buying assets that have already gone up in the hope that they will keep going up. It is what the journalist Zeke Faux, in his book about crypto, calls the "Number Go Up" theory of investing.

This type of momentum investing (or trading) can work brilliantly ... until it doesn't.

The big-picture takeaway from this new research is that growth-stock indexes and portfolios should be weighted based on companies' five-year growth in R&D, sales and earnings, and not on their market capitalization. (For instance, the so-called Magnificent Seven giant technology names are so highly valued on the stock market that they account for about 34% of the value of the S&P 500 index based on their market capitalization. But if they were weighted based on their five-year sales growth, according to FactSet data, that figure would be about 20%).

Institutional investors, fund managers and other professional investors could start applying this research today.

Meanwhile, what does it mean for us ordinary investors?

To me, the most remarkable thing about it is the apparent power of picking stocks based exclusively on companies' five-year growth rate in sales or in research and development. Investors who screen stocks for those things, while completely ignoring price/earnings ratios and other valuation measures, may not be as crazy as they seem.

As Arnott says: "It's surprising how powerful growth is when we ignore valuation levels."

While the R&D figure has been the best growth investment measure, according to Research Affiliates' analysis, it's often hard to get that in a reliable form. Some companies don't separate out R&D spending from broader capital expenditures in their accounts. And even those that do may all count R&D in their own way.

Revenues per share, on the other hand, are easier to find.

According to the WSJ Markets Data Group, using data from FactSet, the following are the 10 stocks in the S&P 500 that have reported the fastest percentage rise in per-share revenues over the past five years: Moderna (up a remarkable 5,000%) (MRNA), Coinbase Global (COIN), DoorDash $(DASH)$, Nvidia (NVDA), Apollo Global Management $(APO)$, CrowdStrike (CRWD), Datadog (DDOG), Block $(XYZ)$, KKR $(KKR)$ and Caesars Entertainment $(CZR.AU)$. Would most investors have picked those as the fastest-growing growth stocks? Maybe not.

The 10 companies reporting the biggest dollar increase in sales over five years, as opposed to percentage increase, included a more familiar set of names. Five of the Magnificent Seven made the cut: Amazon $(AMZN.UK)$, Alphabet $(GOOGL)$, Apple $(AAPL)$, Microsoft $(MSFT.UK)$ and Nvidia (NVDA). Maybe that's no surprise, given how big these companies are. But five others were less expected: UnitedHealth (UNH), Walmart $(WMT)$, JPMorgan Chase (JPM), medical distributor McKesson $(MCK.NZ)$, and Warren Buffett's megaconglomerate Berkshire Hathaway (BRK. B).

There are zero guarantees, and anyone betting some of their retirement portfolio on individual stocks is generally advised to keep those bets small, while keeping most of their money in broadly diversified low-cost funds. But it will be interesting to see how these stocks perform over time. We'll let you know.

-Brett Arends

This content was created by MarketWatch, which is operated by Dow Jones & Co. MarketWatch is published independently from Dow Jones Newswires and The Wall Street Journal.

(END) Dow Jones Newswires

July 29, 2025 10:54 ET (14:54 GMT)

Copyright (c) 2025 Dow Jones & Company, Inc.