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Growth
Investing
Growth investing is investing in the common stock of a company that is
growing its sales and earnings consistently above the economy’s growth rate,
even in a recessionary environment.
Accelerating or constant growth, however, is often
elusive. Historically, a company growing 15% or better is considered to be a
solid growth company. Valuation and timing are critical when buying growth.
Understand
the terminology. A
growth stock that is said to be “too expensive” merely means its valuation
is too high; usually, its P/E ratio is higher than one is willing to pay.
Comparing a company’s price earnings ratio with its growth rate is one of
the tools used to value a stock.
A reasonable price for a growth stock is a PEG of 1;
a P/E ratio equal to a company’s growth rate. The current thinking is that
buying a stock with a PEG of 2 times is fair, although many investors pay
much more. The author, however, feels that paying 2 times growth (or more)
is too expensive. The information age has made it extremely difficult to
find a growth stock at a reasonable price and harder to make money on one.
The market seems to identify good growth companies very quickly and price in
future growth nearly instantaneously, resulting in unrealistically high
price earnings multiples. It’s difficult to find an affordable growth stock.
Nevertheless, if participating in growth stocks, the goal is to pay a
reasonable price.
In some cases, what many investors call growth
stocks, are really “story stocks,” that is, companies with a lot of promise,
but with no earnings, and some with no sales. Research and Development
companies are initially start-up companies. They may transition into growth
companies when they start producing sales and profits. When buying a growth
stock, you need to monitor the company’s rate of growth and profit margins
very closely. The company’s growth rate should be constant or increasing.
If the company is growing
nicely, but its growth rate is slowing down, you can find yourself owning a
great company but a poor investment. In most cases, you as an investor won’t
know that your company’s growth rate is slowing until its books are closed,
and by that time the market has usually already adjusted for the change. For
example, let say a company is growing 30% a year and after you buy the
stock, over the next 4 years its growth rate reduces to 15%, which is still
a very nice rate. If the stock is always trading with its P/E ratio equal to
its growth rate, here is what happens:
Growth
Stock Example
|
Year |
EPS |
Growth %
P/E Ratio |
Price |
|
1 |
1.00 |
30.00 |
30.00 |
|
2 |
1.26 |
26.25 |
33.14 |
|
3 |
1.54 |
22.50 |
34.73 |
|
4 |
1.83 |
18.75 |
34.29 |
|
5 |
2.10 |
15.00 |
31.57 |
You can see from the above example that it’s hard to
make money with growth stocks in today’s economy. Paying a multiple of
growth can be a very costly mistake if growth slows and P/E ratios narrow.
You need to find companies whose growth rates are constant or increasing,
and those are hard to find, and even harder for companies to sustain. The
above illustration is a typical example of why growth stocks are having a
hard time earning good returns. A true growth company has a consistent or
improving growth rate.
Many investors are making
blanket assumptions that all drug, consumer product, or technology companies
are growth companies, just because they have high P/E ratios or were growth
companies in the past. If you really look at the earning trends of these
groups in Value Line, many are not consistent earning growers, but are
priced as such
The objective is to buy a growth company before the
market discovers it. A way to participate in growth stocks, at a reasonable
price, is to invest in small cap growth stocks. Many of the smaller growing
companies in the United States sell at a discount to their larger peers, but
they also carry a great deal of risk. Finding the next Microsoft or Xerox,
however, is often more luck than skill. There are hundreds if not thousands
of promising growth companies that fizzle out and are never heard from
again.
Young adults should avoid overpaying for growth.
Growth stocks are often priced to perfection; a small blip and the stock
price can, and often does, crash instantaneously. Be careful when playing
the growth game.
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