Fundamental Growth Indexing
Select firms by growth rate, then weight them by economic contribution
- Difficulty
- Advanced
- Time to result
- ~months to results
- Steps
- 6
- Confidence
- 98%
Fundamental Growth Indexing separates company selection from portfolio weighting. First, it estimates each company's operating growth by averaging growth in sales, profits, and, when reported, research-and-development spending. Companies must rank in the fastest-growing quartile to qualify. Second, it weights those qualifiers according to the absolute dollar magnitude of their contribution to economic growth rather than their market capitalization or percentage growth alone. This distinction prevents a tiny company with a spectacular but potentially transient percentage increase from receiving an excessive allocation. The resulting portfolio emphasizes companies that are both growing quickly enough to pass a relative hurdle and producing economically significant amounts of new sales, profits, or investment.
Origin
Rob Arnott described the method while discussing the Research Affiliates Growth Index on Masters in Business.
Core principles
- 01Separate business growth from valuation
- 02Measure growth through multiple operating fundamentals
- 03Use percentage growth to identify qualifying companies
- 04Use absolute dollar growth to determine portfolio weight
- 05Avoid overweighting small firms with temporary percentage spikes
How to run it
- 1
Separate growth from price
Treat operating growth and valuation as independent dimensions. Do not assume an expensive stock is automatically a growth company.
Pro tip Evaluate growth before looking at market capitalization or valuation multiples.
Watch out A conventional growth index may classify expensive companies as growth stocks even when their businesses are expanding slowly.
- 2
Collect fundamental growth measures
Calculate growth in sales and profits, then add growth in R and D spending when the company reports it separately.
Pro tip Use the available measures rather than excluding firms that do not report R and D separately.
Watch out A shrinking R and D budget may signal weakening future growth even when current revenue remains strong.
- 3
Create a composite growth rate
Average the available sales, profit, and R and D growth rates to estimate how quickly each company is expanding.
Pro tip Keep the calculation consistent across the eligible universe.
Watch out Relying on one unusually strong metric can misrepresent the underlying business.
- 4
Select the fastest growers
Rank companies by composite percentage growth and retain those in the top 25 percent.
Pro tip Use percentage growth for selection because it makes firms of different sizes comparable.
Watch out Large absolute gains alone do not make a mature company a high-growth company.
- 5
Measure dollar growth
Calculate the absolute dollar amount each selected company added through sales, profits, or the chosen fundamental measures.
Pro tip Distinguish percentage growth used for qualification from dollar growth used for weighting.
Watch out Weighting directly by percentage growth can concentrate the portfolio in tiny, unstable firms.
- 6
Assign portfolio weights
Weight each qualifying company in proportion to its dollar contribution to aggregate economic growth.
Pro tip Review resulting concentrations and trading capacity before implementation.
Watch out The strategy can have higher turnover and volatility than a broad cap-weighted index.
In the wild
A tiny company grows tenfold and easily clears the percentage-growth selection hurdle. Its absolute contribution to aggregate sales or profit growth remains modest, so the dollar-magnitude weighting method gives it only a limited portfolio position rather than allowing the tenfold rate to dominate the index.
→ The portfolio captures rapid growth without taking an outsized position in a potentially temporary success.
Arnott explains that Nvidia achieved extraordinary growth from a lower base while Apple delivered sufficient growth from a much larger base. Both cleared the percentage-growth threshold, and each represented a little over 10 percent of the index because of its substantial dollar contribution to economic growth.
→ Different growth profiles can receive similar weights when both produce economically significant expansion.
Common mistakes
Equating expensive with growth
A high valuation describes what investors pay, not how quickly the underlying company is expanding. Treating the two as synonyms obscures slow-growing expensive firms.
Weighting by percentage growth
Giving the highest weight to the highest percentage increase can create excessive exposure to tiny companies and temporary surges.
Ignoring investment in future growth
Sales and profits alone may miss a company that is reducing the R and D spending needed to sustain future expansion.
Is it for you?
Best for
It is best for quantitative investors designing diversified equity exposure around measurable fundamental expansion.
Not ideal for
It is not ideal for investors seeking passive market replication, minimal turnover, or guaranteed short-term outperformance.
From the transcript
“if you have three different growth rates, growth in sales, growth in profits, and growth in R and D spending, if that's available two of…”
“We select based on percentage growth.”
“So by weighting company in proportion to the dollar magnitude, you're not going to introduce a bias towards frothy, tiny companies that have had just…”
From the episode
Focusing on Growth (Not Market Cap)