growth stock investing and Apple (AAPL)

Apple

The company Apple is one of the great growth stories of the early 21st century, as well as a tale of redemption and return from the ashes.  In a number of respects, however, AAPL is an atypical growth stock.

Ultimately, that’s what I want to talk about.  But I’ve decided to take the long way around and start by writing in general about growth stock investing.

growth stocks

Growth stock investing is all about finding extraordinary companies or industries.

two characteristics

The growth stock investor looks for two things:

–a firm that will expand its earnings per share at a faster rate than the consensus expects, and

–that will do this for longer than the consensus expects.

key judgments

The growth investor has to make two key judgments:

–that a company has the potential for superior growth, and

–that this potential is not yet recognized by the market (meaning is not yet factored into today’s price).

analyzing a growth stock

The analysis of company fundamentals also has two parts:

qualitative, a description of what makes the company unique and what will defend it from competition as it expands.  Most often, in my experience, this can be condensed into an “elevator speech,”  like “AAPL is the leading maker of high-end smartphones, a huge, rapidly expanding global market.” or “Amazon is the dominant force in Cloud services and in online retail, two fast-growing barely penetrated markets.”

quantitative, meaning spreadsheets projecting one’s best guess about how the financial statements–income statement, cash flow statement and balance sheet–will play out over the next several years.

open-ended is good

Often, although the spreadsheets have numbers in all the appropriate fields, the quantitative analysis has an open-ended aspect to it.  I may end up concluding that I’m confident eps will be up at least by 25% in the coming year   …but it could easily be 50% or more.  Uncertainty, yes, but of the best possible kind.

why the elevator speech

The elevator speech has two important purposes:

–it forces the analyst to step back from the numbers and pay attention to what the company’s competitive advantage is

–as a growth idea gets long in the tooth, it’s most often the story that breaks down, not the numbers.  So the qualitative analysis ends up being an early warning sign that one should reduce exposure or exit the stock entirely.

 

More tomorrow.

 

 

 

 

selling: different styles

I’ve been thinking some more about what I wrote last week about selling in Disney(DIS) stock.  The thrust of my reaction to the sharp decline was, and still is, mild bemusement that selling only emerged as the company reported weak results from ESPN.  It’s not that disappointing earnings should not generate selling.  It’s that the handwriting had been on the wall about ESPN–and in vividly hued bold print–for some time before DIS’s 2Q15 earnings report.

Why no stock weakness earlier?  This would have been my strong expectation. I’m not talking about the results somehow being leaked to outsiders by the company.  Rather, I’d have thought that the market would have put two and two together and acted weeks or months ago on publicly available information about the cable industry–like Nielson reporting of subscriber losses at ESPN.

My conclusion was that the sharp fall in DIS shares on its earnings report might be evidence that Wall Street just didn’t know there were problems at ESPN, despite what I consider clear signals of trouble being visible for a considerable time.

I still think it is generally true that the stock market is becoming less efficient–and more like I perceive the bond market to have been throughout my time as an investor.

I’m no longer sure that DIS is evidence for my thesis, though.  Here’s why:

The key to successful investing in growth stocks is being able to sell them at the right time, meaning exiting as the firm is going ex-growth and before the rest of the world realizes this.

To me, the key signal is the breakdown of the conceptual “elevator speech” explanation of what gives the company in question its extraordinary growth potential.  In my experience, if we’re waiting for the first disappointing earnings report, we’re almost always hanging on too long.

The presupposition here is that the potential upside from my exit point is (far) less than the downside from being a holder of the stock when the disappointing earnings are released.  This assumes, of course, that I can recognize the point at which all the possible future good news–and maybe more than that–is already factored into the stock price.

My approach didn’t work so well for me in the case of DIS, where I failed to anticipate the fabulous success the company has had in its non-Marvel, non-Pixar movie business.

There is a second approach to growth stocks.  It argues that a well-managed company normally has more earnings growth tricks up its sleeve than any outsider is able to understand.  Therefore, it’s always too risky to sell when the conceptual story begins to unravel.  Better to wait for actual proof to come in through bad earnings.  Yes, one might lose 10% by selling after the bad report.  But that’s better than exiting at 40% below the stock’s peak.

In fact, I took this second approach myself, early in my investing career.

The difference in my thinking from last week and now:  my first thought was that information is not circulating on Wall Street as fast as it used to; my second thought is that investors may have the same information as always but they’re just using it differently.

Practical implications?  …they may be substantial.  My conclusion is still to look for more evidence.  My tendency is going to be to hang onto growth stocks for a bit longer than I might otherwise, though, figuring that others are going to do the same thing.   So the cost of waiting to find out if there’s another growth spurt left in a maturing company may be lower than it has been in the past. And I may no longer be committing the cardinal investment sin of underestimating the information the other guy has.

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.