exiting a growth stock

To paraphrase/summarize my last few posts, the key to value stock investing is to buy when things couldn’t be worse.  For growth stock investing it’s to leave the party when things couldn’t seem better.

Generally speaking, the key to making a successful exit from a growth stock is to always keep in mind the qualitative “elevator speech” whose essence is that it contains what you think gives the firm a special edge.  When that story begins to erode–maybe new competition emerges, or the target market the firm is exploiting gives signs of being saturated, or tastes change–it’s time to edge toward the door.  The important thing to remember is that this erosion occurs long before earnings growth begins to slow.

The first disappointing earnings report is typically followed by continuing bad news, so it’s not to late to get out then.  But that first bad report is typically a long way from the top for the stock.  The leading indicators are what really count.  They differ from stock to stock.

Take Wal-Mart as an example.  Its main business was opening superstores in small towns.  Government statistics could have told us how many such towns there are in the US.  That data allow us to figure out how many years of growth the company has before it’s forced to do something different.

Deviations from the norm are another indicator. Starting a second brand suggests #1 may be getting a bit long in the tooth.  Opening outlets in notoriously difficult markets like Los Angeles or New York might also be a signal.

A PE that’s too high for the firm to ever grow into is a third signal that things can’t get much better for the stock.

 

One caveat, something that makes the situation trickier:  most growth companies are unable to reinvent themselves when their initial good idea runs out.  The best of the best, however, are able to do so.  Some of them can do this multiple times.

Apple, for example, has had several lives.  It was initially the story of a near bankrupt company coming back from the brink (led, ironically by the man who put the enterprise on the road to the precipice in the first place, Steve Jobs).  Then it was the iPod company.  Then it was the iPhone company.   Most recently, it’s the firm Tim Cook saved from the craziness of having a phone that’s too small and a tablet that’s too big.

These situations are rare, however.  And there’s always time to change your mind after reducing a position or eliminating it entirely.  So the possibility that stock X might be another AAPL isn’t enough, io my mind, not to exit once the qualitative story begins to break down.

two aspects of securities analysis: quantitative and qualitative

quantitative analysis

The quantitative aspect is easier to describe.  It, however, is much more complex and detailed and may take months to complete.  As a professional, I always thought part of the art of portfolio management was in deciding how much of this I had to do before I bought a stock, how much I could obtain from brokerage house securities analysts, and how much I could leave to fill in after I established a position.

The quantitive plan consists in a projection of future company performance–revenues, operating profits, interest, depreciation, general expenses, taxes…–for each line of business and for the company as a whole, over the next several years.  Creating spreadsheets this detailed is an ideal that’s striven for but seldom reached in practice.  That’s because companies rarely disclose this much information in their SEC filings.

Lengthy reports, called basic reports, issued by old-fashioned (i.e., “full service”) brokerage houses are the best example of what a quantitative analysis should look like.  Signing up for Merrill Edge discount brokerage will get you access to such reports.

The most important thing about them, in my view, is the analytical work, not necessarily the opinion.  I think the Merrill analyst covering Tesla, for instance, does extremely good work.  All the relevant issues and numbers are clearly laid out.  Last I read, he thought that fair value for the stock was around $75 a share.  Although he provides very valuable input, and he may ultimately be proven correct, I think he’s way too pessimistic about the stock.

qualitative analysis

This is the general concept behind an investment.  It’s extremely important–more important than the exact numbers, in my view–but it may be as short as an elevator speech.  In most cases, the shorter the better.

Examples, many of which are not current:

–Wal-Mart builds superstores on the outskirts of US cities with a population of 250,000 or less.  They offer better selection and lower prices than downtown merchants do, so they take huge market share everywhere they open.  There are a gazillion such towns left to exploit.

–J C Penney is trading at $25 a share. It owns or controls property that has a value, if rented to third parties, of $50 a share, plus a retail business that is making money.  The latte is worth more than zero as-is.  Let’s say $5 a share.  Taking control of JCP and breaking it up could double our money.

–Adobe is changing from a sales model for its software to a rental one.  This will eliminate counterfeiting, which is probably much more extensive than anyone now realizes.  We know from other industries that going from buy to rent probably doubles profits, even without considering eliminating theft. No one seems to believe this.   Therefore, ADBE’s profit growth over the next two or three years will be surprisingly good.

–Company X is a cement company.  It’s currently beaten down by an economic slowdown and is trading at 40% of book value.  At the next economic peak, it will likely be trading at 100% of book–which will be 20% higher than it is today.  Therefore, the stock should triple in price.

More tomorrow.

why selling is the most important for growth investors

Value investors make money by finding companies that are undervalued based on the state of their business today.  Their capabilities typically become undervalued because of bad management, a temporary misstep in judgment or a cyclical downturn.  Any of these factors will usually trigger an excessively negative emotional reaction by the market–creating the buying opportunity.

Growth investors like me, on the other hand, are dreamers.  We try to find companies that will likely be expanding their profits at a faster rate than the market expects, and for a longer time than the market expects.

Where the value investor asks “What can go wrong in the here and now from this point on?” and answers “Nothing that the market hasn’t already discounted three times over,” the growth investor asks “What can go right over the next few years that market is unwilling to pay for today?”

 

A generation ago, the classic growth stock was Wal-Mart (WMT), a company that built superstores on the outskirts of small towns with under 250,000 population and prospered by taking market share away from inefficient mom and pop local merchants.  It started in Arkansas and grew…and grew…and grew, for a long as there were new small towns to attack.

In this generation, we might think of Apple (AAPL) or Google (GOOG).  In the former case, it was the ability of a highly skilled management to resuscitate the brand and produce the iPod and then the iPhone that the market didn’t understand when the stock was at $25.  With GOOG, it’s the power of search that was vastly underestimated.

If a stock is going to reach, say, $100 a share–the growth investor’s dream–whether we pay $10 or $12 or $20 isn’t the crucial decision.   Getting on the train at some early stop is all that matters.

Selling at the appropriate point, however, is much more crucial.

How so?

what goes up…

Let’s say the market expects that a certain company is going to grow profits at 15% per year for at least the next several years.  The next quarterly earnings report comes in at +20% in profit growth; management says it thinks it can continue to grow at the higher rate.

Two positive things typically happen:

–the stock rises to adjust for the higher reported earnings, and

–the price earnings multiple expands, as the market begins to factor in the idea that the firm can grow more quickly than it thought.  In other words, the price rises more than simply the good earnings report would justify.

Let’s say that the quarter after that, earnings come in at +25%–and that management continues to make bullish comments about its future.

The same thing–two levels of upward price adjustment, higher earnings, higher multiple–happens again.

For a true growth stock, a WMT or an AAPL or a GOOG, this process of upward adjustment can go on for years.

At some point, though,

must come down

…the stock market gets tired of being wrong on the downside.  It makes an emotional swing to the upside that can’t possibly be justified by the company’s fundamentals   …ever.

Typically, this is expressed as a sky-high price earnings multiple.

In addition, in my experience, the life span of a typical shooting star earnings grower is about five years.  After that, earnings growth begins to slow.  The crazy multiple expansion comes toward the tail end of the super growth period.

 

As the market senses that slower growth is in the offing, the process of upward adjustment goes into reverse.  The stock declines to reflect weaker than anticipated earnings, and the price earnings multiple begins to contract.

This is usually a very ugly process, with the stock declining much more than one might ordinarily expect.

 

The trick for a growth investor is to exit the stock, at least in large part if not totally, before this happens.

 

More on Monday.

 

 

 

why buying is the key decision for value investors

Value investors like to describe themselves as buying companies worth $1 for, say, $.20 and selling them for $.80.  Less ambitious practitioners say buying for $.30 and selling for $.70.   But the idea is the same–buy at a deep discount, sell at a slight discount.

What remains unexpressed, but what’s crucial for value investors, is that the firm in question is not being assessed on any pie-in-the-sky future developments, but on an evaluation of what the company as it stands now is worth.

Three types of situations get value investors particularly excited:

–periods of general stock market undervaluation,

–overall business cycle slumps, or specific industry group declines, when the market fears that an (inevitable) upturn won’t happen and decides to unload the underperforming stocks into the market for whatever they can get, or

–companies that are industry laggards and which would fare far better if run by more competent managers.

In a sense, all of these situations involve temporarily damaged goods.

In each case, value investors also have plenty of data for figuring out what normal or reasonable prices for now-undervalued companies should be.  The data might be projections from past industry or economic cycles about how far earnings might rebound during an upcycle and how far price earnings multiples might change (usually expand).  In the case of badly run firms, the comparison is with healthy companies in the same industry.

In every instance, however, it’s a relatively straightforward thing to set a target price–what the company would be worth in better times.

The more difficult question is at what price to buy.

Investors will certainly demand a premium, say, 20% or 30%, for taking the risk of making a purchase while a business may be doing badly or while the overall market is cringing in fear.

Beyond that, value investors seem to me to fall into two types:

–those who are willing to buy at what they consider a rock-bottom price, regardless of the near-term outlook, and

–those who are waiting to see an initial ray of sunshine, or a “catalyst,” that convinces them that the worst is past.

In the first case, the skill is in judging the bottom.  In the second, it’s finding the turn upward before the market in general does.  But in both cases, it’s the decision to buy that’s the key to success.

 

 

 

 

comparing growth and value styles

 

Growth                                                        Value

stock volatility high                                   low

character aggressive                                   defensive

upside high                                                    limited

downside can be high                                 low

firms have very bright future                  cheap assets

outperforms bull market                         bear market

benefit from market greed                      market fear

(sell high)                                                       (buy low)

uncertainty extent of rise                        timing of rise

portfolio size 50 issues                            100

 

All this is leading up to talking about why buying is the crucial step for value investors, selling the most important for their growth counterparts.

growth vs. value test: my answers

The growth stock investor’s answer:  Joe’s, of course.  Why?  I pay $18 for the stock now.  At the end of five years, earnings per share will likely be $2.70.  Assuming the stock keeps the same p/e multiple, its price will be $48 and I will have almost tripled my money.

Look at Bill’s in contrast.  I pay $10 for the stock.  At the end of five years, eps will be up 61% and I will have collected $2.50 in dividends (which I may have to pay tax on, but let’s not count that here).  Assuming the stock keeps the same multiple, it will be trading at $16.10.  Add in the dividends and the total is $18.60.  That’s a return of 86%, or about half what I would get from holding Joe’s.

One more thing.  Maybe in five years, people will start to worry about whether Joe’s can continue to expand at its current rate.  As a result, the p/e multiple could begin to contract.  Maybe that will happen, maybe not.  But even if it does, the multiple will have to drop from 18 to 12! before I would be better off with Bill’s.

The value stock investor’s answer:  It’s obviously Bill’s.  Joe’s has a much more aggressive  growth strategy.  Maybe it will work, maybe not.  I don’t see why I have to decide.  A lot of the potential reward for success is already built into Joe’s current stock price.  And if Joe’s strategy is unsuccessful, the stock has a very long way to fall.

If Joe’s strategy doesn’t work, then I’m much better off with Bill’s.  On the other hand, suppose it really is the way to go.  In that case, either Bill’s management will see the light and adopt a more aggressive stance itself, or the board or activist shareholders or a potential predator (Joe’s?) will force a change.  And the stock will skyrocket.  While it may take a little more time, I’ll enjoy all the rewards of backing the winning strategy without taking on the higher risk of holding Joe’s.

It’s a question of temperament.  A conversation between the growth and value sides could have several more rounds before it degenerated into name-calling, but you have the basic idea already.

Maybe the most salient points to be made about each answer are:

–not that many companies grow so rapidly as Joe’s without any hiccups;

–wresting control from an entrenched management is not that easy (look at the sorry history of  Western-style value investing in Japan–or most places in Continental Europe, for that matter–for confirmation).  It may not be possible, and could be a long and arduous process in any event.

testing for style–growth investing vs. value investing

Yes, I was supposed to be writing about trading.  But I figured it might be useful for readers to figure out whether they tend to like growth stocks or value ones before going further.  Here’s a test I heard about while I was at a value-oriented shop in the early 1990s (it’s a rerun of a one of the first posts I wrote in 2009.  Try not to look back to see the answers, which will appear again tomorrow.):

The Rules

I’ll describe two companies.  Both are retailers, operating in the US and selling identical merchandise.  They are located far enough away from one another that there is no chance of them competing in the same markets for at least ten years.

Both have first year sales of $1,000,000.

Both have an EBIT (earnings before interest and tax) margin of 15% and pay tax at a 33.3% rate.

Therefore, both have first-year earnings of $100,000.

Each firm is publicly traded and has 100,000 shares outstanding.  Earnings in year 1 are $1/share for both companies.

Money reinvested in the business is currently generating $2 in sales for every $1 invested.  There’s no lag between the decision to invest and the generation of new sales.

Both can borrow up to 20% of earnings from a bank at a variable rate that is now 7%.

Earnings and cash flow are the same (just to keep it simple).

Company 1:  Bill’s Stuff

Bill’s management wants to take a conservative approach to a new business.  It decides that it will:

reinvest half of its cash flow back into the business,

pay a dividend of $.50 a share ($50,000/year),

keep any remaining cash in reserve in a money market fund.

So,  in year 2 Bill’s generates $1,100, 000 in sales, earns $165,000 in ebit and $110,000 ($1.10/share) in net income.  It reinvests $55,000 in the business, pays out $50,000 in dividends and keeps $5,000 in reserve.

Let’s assume the company can continue to operate in this manner for as far as we can see.  Then, the company’s investment characteristics are:

10% earnings growth rate

$.50 dividend payment

no debt; small but growing amount of cash on the balance sheet

Let’s assume Wall Street is now willing to pay 10x current earnings for the company’s stock.

Company 2:  Joe’s Things

Joe’s management believes that expansion opportunities are extraordinarily good right now.  It decides that it will:

reinvest all the company’s cash flow back into the business,

borrow the full 20% of earnings that the banks will provide and reinvest that in the business as well.

In year 2 Joe’s generates sales of $1,240,000 and ebit of $185,000.  After interest expense of $1,400 and tax, net income is $122,400 ($1.22/share)..

For year 3, Joe’s can borrow another $4,500 and does so.  Therefore, it reinvests $126,900 in the business.  It generates about $1,500,000 in sales and ebit of $225,000.  After interest and tax, net income is about $149,000 ($1.49/share).

Assuming that Joe’s can continue to expand in this manner indefinitely,  the company’s investment characteristics are:

22% earnings growth rate,

modest and slowly-rising bank debt,

no current income.

Let’s assume Wall Street is willing to pay 18x current earnings for the stock

The question:   Which one would you buy?

Answer tomorrow.