…meaning for the past thirty years or so that I’ve been in the business.
What makes a growth stock is faster than expected expansion of earnings per share, that carries on for longer than expected.
Let’s say a stock is now trading for $20 a share. It earned $.90 a share last year; the consensus of Wall Street analysts is that eps will grow by 11% to $1.00 this year. Under these assumptions, the stock appears overvalued–one would be paying 20x expected earnings for 11% growth.
Assume, however, that our careful securities analysis, based, say, on the introduction of a badly understood but potentially transformational new product, reveals that eps will grow by 35% (and maybe more) this year–and beyond. If we’re right, the stock is trading at 15x expected earnings for 35% growth. It’s a steal.
Stage 1. eps acceleration.
a. The company reports 20% year on year eps growth in 1Q16, vs. expectations of 10%. The stock goes up, for two reasons:
–stock rises by, say, 20% because beliefs about the level of current earning power are revised up, and
–the stock’s PE ratio expands, meaning the stock rises by another, say, 5% – 10%, on the idea that a permanent upward change in the firm’s earning power may be under way.
b. The process repeats itself in following quarters as long as expectations lag company performance.
Stage 2. plateauing
In my experience, plateauing almost always results from a negative change in the qualitative story that’s driving the stock. Earnings per share still look fine. But there are indications that the force propelling them is looking long in the tooth. Let’s say a retailer’s results have been going up for several years, both because of increasing same store sales growth and geographical expansion into new markets. But now sales in the oldest stores are starting to flatten out, maybe even beginning to decline–and the firm has just entered the last 10% of its potential expansion program.
Typically, this is also the time when the stock’s PE ratio has expanded to crazy-high levels. So, too, consensus expectations for earnings growth.
This is also usually the time when the first portfolio investors in are beginning to make their way to the exit.
Time can be another indicator. Stages 1 and 2 together tend to play themselves out over five years or so.
Stage 3. weakening comparisons
a. The company reports earnings that no longer surprise on the upside. They may be perfectly fine and in line with company guidance, but they’re less than investors expect. The realization begins to dawn on holders that the peak of profit growth may have passed.
Now, the stock goes down for two reasons:
–current earnings growth expectations are revised down, and
–beliefs about long-term earnings power come down as well, meaning the PE contracts.
b. This process continues.
–The best growth companies are able to reinvent themselves, sometimes more than once, thereby prolonging their five-year growth cycle.
Microsoft, Cisco, Amazon, Apple are all instances. In Apple’s case, the company was first the plucky PC company come back from near death. Then it was the iPod company. Then it became the iPhone maker. Each reinvention triggered another growth cycle.
–The fall from grace in Stage 3 is often quite ugly and can last for a long time. The potential buyers of a fallen angel are predominantly value investors, who are typically only avid purchasers at a discount to some notion of intrinsic value.