The main idea behind investing in a growth stock is that the company whose equity you’re buying will show earnings growth that’s much higher than the stock market consensus expects, for much longer than the market expects.
AAPL, MON or COH are recent examples of successful growth companies. In their day, WMT, CSCO, MSFT, ORCL, even IBM were growth stocks.
Examples of companies that had seemingly good ideas that failed to experience a multi-year period of strong earnings growth also abound. No one remembers their names, though.
Consensus data less useful for growth stocks
Maybe the most important characteristic of growth companies in my opening sentence is the assumption that the consensus is wrong and has materially underestimated how rapidly the company in question will grow, and for how long.
One practical, straightforward consequence of this is that the kind of computer screening that a value investor routinely uses to find undervalued securities, which uses historical data plus consensus estimates, is of little use.
In consequence, although the growth investor does use historical data and may find the germ of an idea from an industry expert, he most often has to rely on his own research. Sometimes this comes from his own experience. For example, Peter Lynch of the Fidelity Magellan fund, perhaps the most famous stock investor of the late Seventies and early Eighties, wrote that he became interested in Dunkin’ Donuts, once a growth stock, because he used to buy his coffee there on the way to work.
Qualitative research is important
All research has, in my opinion, a qualitative and a quantitative element. For value investors, the latter is more important. For growth investors, though, I think the qualitative description is always the key. Yes, you have to have spreadsheets that have point estimates of what future revenues and earnings will be. But for the best growth stocks, there’s always a sense of–the earnings will be up at least 30%, but they could be a lot more than that. In contrast, the qualitative story–what unique attributes of the company allow it to grow so fast–remain constant.
Rules of thumb for growth investors
There are some historical rules of thumb that you can use in growth investing, however:
1. the process of establishing itself as a fast grower normally takes several years. This is a combination of the company developing its operations and of Wall Street gradually coming to recognize the firm for what it is;
2. as stock market outperformers, growth stocks rarely last more than five years;
3. the truly great companies, like WMT or MSFT, are able to reinvest themselves and extend the growth period for much longer periods;
4. growth stocks typically reach their peak of stock market popularity and their highest relative P/E multiple just as growth is beginning to slow;
5. because of this, when they go ex growth, these stocks often face a protracted period of underperformance;
6. signs of trouble always, always surface in the qualitative analysis before they make themselves evident in earnings.
Common growth stock errors
1. selling too soon. The average yearly return of stocks over very long periods of time is about 10%. Compared with that, a 30% or 50% return looks good. Also, from a value stock mindset, 50% may be all that you can expect. Not so with growth stocks, however. The key question should be whether the basis growth story for the company is still intact (surprisingly strong growth for a surprisingly long period). If so, don’t sell. Remember, too, that good growth stocks don’t come around that often and aren’t that easy to identify.
AAPL is a good recent example. The qualitative story has been simple: the iPod would be more successful than most thought; the retail stores would provide a new, profitable distribution system; and there would be a “halo effect” that would spark new interest in AAPL’s computer offerings. In the four years from late 2003 to late 2007, the stock rose almost 20x.
2. missing the signs of “reinvention”. Many–make that: most–growth companies are one-trick ponies. They have one, admittedly, exceptionally good, idea, but once that is executed, the company has nothing left. The truly great ones, though, have strong management that recognizes this issue and is actively planning far in advance for what comes next. AAPL, for example, has the iPhone, which on some measures makes up almost half its current earnings. AMZN now sells an awful lot more than books, and is a leader in the emerging field of “cloud” computing. MSFT went from personal computer operating systems, to spreadsheet and word processing software, to the Windows user interface.
3. missing the signs that the party is ending (the reverse of #2)
a. focussing solely on earnings. Emphasizing the quantitative over the qualitative can get you into trouble in another way. Strong earnings growth can be sustained for a number of quarters even as the market for a company’s offerings is nearing saturation or as new competition is preparing to enter the market. Scanning the competitive environment for threats, or looking a company-specific metrics, like the rate of growth of new orders, or sales growth experience with recently-opened stores, will likely turn up signs of slowing growth before they turn up in reported results.
b. accepting a stratospheric (30x+) price/earnings multiple as normal. In the early years of a company’s life as a fast grower, a very high multiple is typical and usually well-justified. But a high multiple means higher investor expectations, which require high, and accelerating, earnings performance to be maintained. In, say, year four of rapid expansion, surprisingly high earnings growth becomes more difficult to achieve.
Why? Any firm (not run by crazy people) attacks its best growth opportunities first. As it expands, those get used up and the company has to turn to progressively less lucrative possibilities. At the same time, the increasing size of the company means that a lot of work has to be done just to achieve higher profits than the year before.
At some point, a market reaches saturation–that is, no new customers want or need a product. A one-idea company shifts from the situation of having more customers than it can service, to dealing only with replacement demand. Look at the pattern of AAPL’s iPod sales, for example, or SIRI’s satellite radio experience.
A very high P/E isn’t by itself a sell signal. But it is a warning sign to check growth assumptions extremely carefully. And the highest multiple often comes just as earnings performance is set to flag.