Growth vs. Value: II. Growth Investing

Growth Investing

Growth investors are dreamers.  In their efforts to locate fast-growing companies, they’re always trying to imagine what the world will look  like two or three (or more) years, and what kinds of companies will be able to exhibit surprisingly strong earnings growth (stronger than the consensus expects) over that time horizon, growth that will persist for longer than the consensus believes.

In the ideal case, the company’s projected earnings growth profile will also have an open-ended quality to it, in two ways:

*First, I should have confidence that growth will be at least, say, 20% a year.  But I should also have it in the back of my mind that, if the cards play out right, it could be 30% or even higher.

*Also, there should be no concrete evidence that the growth I foresee will come to an end soon.  Intellectually, we know that the fast growth period will end eventually.  But that’s a much different situation from being fairly certain the market will be saturated with the company’s products, and the company will therefore go ex-growth, within a short while.

A growth company typically has one or more “special” characteristics that protect it from competition.  The firm may own patents or other intellectual property, for example.  Management may be unusually skilled, or understand the company’s markets particularly well.  The firm may be addressing an underserved demographic or be the first to bring a new type of product or service to market.

It seems to me the typical growth stock retains its privileged status on Wall Street for about five years.  Some firms can go longer with a single product or service, but that’s unusual.  The best companies, like Wal-Mart, Microsoft or Cisco were in their heyday, are all able to re-invent themselves and generate a series of growth spurts over an extended period.

Wal-Mart, Prototypical Growth Company

The prototypical mega-growth stock of the past several decades has been Wal-Mart.  In very simple terms, this is what I think it did:

Wal-Mart initially protected itself from competition by concentrating on towns of 250,000 or less in population, which depended on small local merchants for general merchandise.  Wal-Mart would open a large discount store on the outskirts of town and, through much lower prices and wider selection, soon dominate commerce in the area.  That was its initial growth phase.

When the company saw it was beginning to run out of small towns in the US, it decided to bring the Wal-Mart concept to Mexico, the UK and elsewhere.  It also began to enter larger towns and cities at home.  And it began to open warehouse clubs.  That was phase two.

Some time later, it started another growth spurt by expanding into the supermarket business.

Is Wal-Mart a growth stock today?  I don’t think so, not in the sense I’ve described above.  It still has extremely shrewd management, and it is growing at a time when most other companies are struggling.  It may still be an attractive stock to own.  But it’s too big to be able to generate the growth rates it did in the Eighties and Nineties.

Variants On “True” Growth

This brings me to two variants on “true” growth that should be mentioned:

*Growth At a Reasonable Price (GARP).  What would you pay for the type of open-ended growth I’ve described at the outset?  As a rough rule of thumb, a growth investor would probably say he will pay at most a multiple of this year’s earnings equal to the company’s perceived growth rate.  In other words, up to 30x earnings per share for a company growing at 30% a year.  In contrast, a GARP investor takes a somewhat less risky (but potentially lower reward) approach.  He typically has a p/e multiple, say 20x, above which he won’t go, no matter what the current growth rate.

*relative growth.  Finding true growth stocks is a tall order.  And if you believe the five-year life span, you have to figure on replacing up to 20% of your stocks annually.  So some managers widen the definition of growth companies by including all firms having a long-term earnings growth rate of, say, 15%, or some other number comfortably higher than the growth of the nominal GDP of the US.  Or they may say they will invest in the fastest growing companies in each sector of the market, acknowledging that some sectors may not be very “growthy” at all.

General characteristics of the growth style:

* stocks tend to be more volatile, day to day, than the market.  They typically have better-than-average upside potential than the market but fewer defensive characteristics.

*managers receive a report card with every quarterly earnings announcement.  Thus, they have a very clear idea when they expect the stock to react, but less certainly about exactly what that reaction may be.

*if an investor finds a growth stock in early stages, it may be impossible to tell how high earnings will get or how quickly they will rise.  In fact, good franchises tend to keep on exceeding expectations.  The major worry about a growth stock, as I will discuss below, is having it go ex-growth.  The major exercise of judgment by and investor, then, is not when to buy but when to sell.

*one of the ground-level beliefs of the growth investor is that the company’s earnings reports will continually show the consensus to be wrong by being too low.  So quantitative screens aren’t as useful as for the value investor.  Managers will typically monitor the pattern of changes in brokerage analyst quarterly earnings estimates, though, as well as looking at the extent to which each earnings report surprises positively.

Going ex-Growth

Growth managers worry the most about their companies going ex-growth before the manager realizes what is going on and can sell.  Here’s why:

When a company reports surprisingly good earnings, the stock typically rises. This advance will have two components:  an increase to factor in the higher level of earnings + an increase in the p/e multiple the market places on them.  This can be an explosive mix.  Let’s assume a stock is priced at $20 on the idea that eps growth will be 25%, from 80 cents to $1.  If the actual number turns out to be ten percentage points higher, 35% eps growth–or $1.08 instead of $1, and as a result the multiple expands to 28, then the stock stands to rise by 50% to $30.  So that 8 extra cents in earnings adds $10 to the stock price.  Apple’s rise from about $10 to $200 is a good recent example of this.

This is great on the upside.  But eventually the market begins to adjust its expectations higher.  At some point, either expectations reach a level that simply can’t be met, or the company itself begins to mature and its rate of earnings growth begins to plateau or slow.

Typically, this occurs at a time when the market has complete faith in the company.  As a result, the stock is trading at a stratospheric p/e.  When the first less favorable earnings report comes out, the same process that drove the stock up starts to work aggressively in reverse.  The contraction in p/e ratio, which begins with the first “bad” earnings report, can be devastating.

Microsoft is an illuminating example.  From 1996-1999, earnings per share grew at 50% a year.  The stock peaked at the end of 1999 at a price of about $60, or 80x eps of 75 cents.  MSFT’s p/e at that time was more than 3x the multiple of the market.  Then growth quickly shifted into a much lower gear.

For the first half of this decade, eps growth for MSFT was very slow, before picking up a bit over the past two years.  MSFT will likely earn about $1.75  for 2009.  This is 2.3x the company’s eps for 1999.  Nevertheless, MSFT trades at less than a third of its 1999 peak.  Why?

The main reason is that the stock’s p/e multiple has contracted to 10, or .85x the market average.   That is to say, relative to other stocks, the market is now only willing to pay a quarter of what it did in 1999 for MSFT’s much faster-growing earnings stream.   This is what going ex-growth–ending the period of extra-fast earnings expansion–does to a high=-flying stock, and why it’s the growth manager’s biggest worry.

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