Tag Archives: investment strategy

exiting a growth stock

June 30, 2015 By in from growth to value: the life cycle, growth vs value Tags: , , , 1 Comment

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.

why selling is the most important for growth investors

June 26, 2015 By in from growth to value: the life cycle, growth vs value, mean reversion Tags: , , , , , , , , 1 Comment

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.

 

 

 

surviving the next twelve months (iv)

June 12, 2015 By in bond market, Constructing a Portfolio, Portfolio management, securities markets, stock market, Strategy Tags: , , , , , , , , Leave a comment

what makes me optimistic

I’m a growth stock investor.  So I’m optimistic by nature.

More to the point, the two worries about thinking stocks will go sideways to up as the Fed normalizes interest rates are that:

–recovery in the US may continue to be sub-par..  

If so, the normalization process is going to take a looong time, since the Fed’s goal is to raise interest rates at a slow enough pace that the economy in unaffected.  Yes, the Fed may make a mistake, but the error it typically makes is to wait too long to raise rates, not to raise them too fast.

In addition, there’s serious discussion in economic circles that maybe the way we have measured economic progress in the US in the post-WWII era has passed its “use by” date and isn’t capturing what’s going on in an Internet-centric world.  After all, it took many years for government data to acknowledge that personal computers enhanced productivity and increased consumers’ well-being.  We’re now in the midst of a much greater period of change–the baton-passing from Baby Boomers to Millennials and the demise of the post-WWII corporation designed on the model of the 1940s Army.

Maybe the economy is a lot hardier than we now think.  If so, the strength of earnings growth may not be the issue the market perceives it to be.

–the rest of the world is a mess…

therefore the 50% of S&P 500 earnings that comes from abroad will  be a source of disappointment.

As far as commodity-based emerging economies are concerned, “mess” is probably an apt characterization.  But they’re (thankfully) only a tiny portion of the foreign 50% of S&P earnings.  The key areas for the index are Europe and Asia, especially China.

As far as Europe goes, there’s evidence that the worse of the recession is behind it.  The euro may have bottomed against the dollar, as well.  The EU is still struggling with the problem of Greece.  But that’s not because Greece is a key economic driver for the EU (quite the opposite), but because Brussels fears that allowing/forcing one member to leave the union will set a precedent, and encourage separatist political parties elsewhere.

I have no idea whether Greece goes or stays.  But I think that the negative economic consequences for Greece–Cuba is the only analogue I can come up with, and it’s not a very good one (Argentina?)–of leaving the EU will be so devastating for the country that Grexit itself will silence separatists.

There are also the first signs of economic stabilization in China.

So maybe the half of S&P earnings that come from abroad also won’t be as bad as the market now thinks.

an active strategy

areas to avoid–stocks whose main attraction is their dividend

areas to emphasize–Internet economy, firms catering to Millennials

 

 

surviving the next twelve months (iii)

June 11, 2015 By in bond market, junk bonds, Portfolio management, securities markets, stock market, Strategy Tags: , , , , , , , Leave a comment

In the past in the US when the Fed has raised interest rates from recession-emergency lows, bonds have gone down and stocks have gone sideways to up.

Will this time be an exception?   …another way of saying, Will stocks go down this time around?

The generally accepted explanation of the divergence between stocks and bonds while the Fed is normalizing interest rates after a downturn is that the negative effect of higher rates is offset, in the case of stocks, by the positive effect of strong earnings growth.  Bonds–other than junk bonds, or municipal bonds–don’t have this offsetting factor.  So for Treasuries the news is all bad.

(There are at least two reasons why interest rates matter for stocks:

–broadly speaking, people (me being a possible exception) don’t actually want to own stocks.  What they want is to own liquid long-term investments so they can fund their retirements and send their kids to college.  Those can be either stocks or bonds.  A decline in the price of bonds makes them more attractive, taking some of the shine off stocks.

–in broad conceptual terms, the worth of a company should be related to the value in today’s dollars of its future earnings.  To the extent that investors use today’s interest rates to discount future earnings back to the present, rising rates will result in lower present values.)

 

I remain squarely in the “sideways to up” camp, but I can see, and am monitoring, two possible worries that may weaken the case for s-t-u:

–in what has been to date a sub-par rebound from recession, earnings growth may not be as strong as in prior recoveries, and

–the S&P 500 is a global index, about half of whose earnings come from abroad.  Even if US-sourced earnings are great, the same may not be true for foreign-sourced.  In particular, an increase in the value of the dollar vs. the euro caused by increasing interest rate differentials (the worry of the IMF and World Bank) could mean a lower dollar value for EU-sourced earnings (which make up about a quarter of the S&P 500 total).

More tomorrow.

 

surviving the next twelve months (ii)

June 10, 2015 By in bond market, Constructing a Portfolio, currency markets, Current Market Thoughts, growth vs value, stock market, Strategy Tags: , , , , , , , Leave a comment

two types of tightening

The Fed raises rates in two different situations:

1  to slow down an overheating economy.  This is not where we are now.  In the overheating situation, the economy is expanding at an above-trend rate.  Inflation is accelerating.  Wages are rising rapidly.  The stock market is frothy.  The long bond is trading at inflation +2% – +3% (meaning a nominal yield of 4% – 5%, in a 2% inflation scenario).

As the Fed ups short-term rates, what  follows is a garden-variety recession/bear market.  Bonds go down.  Stocks go down.  The damage to stocks is worse than the damage to bonds–often by a lot.

Again, this is not the situation we’re in now.

2)  to restore money policy to normal after a period of extreme easing aimed at ending a recession or combating a severe economic shock.  That’s where we are now.

 

In situations like this, bonds go down but stocks go sideways to up.  There’s no theoretical reason I can see for the latter behavior.  It happens, I think, because, unlike the overheating situation,  the Fed doesn’t intend to bring growth down dramatically.  It just wants to wean the economy off a sugar high of very easy credit.

Two things make todaydifferent from past rate normalization periods, however:  the amount of easing has been very large and of unusually long duration; and dysfunction in the legislative and executive branches in Washington has meant fiscal policy has failed to do its part come to the country’s support, other than in the earliest days of the financial crisis.

Some argue that beause of this, today’s situation may be different enough that the past won’t be a sure guide.  I’m going with history.  But I take th point that we can’t just be on cruise control.

two different portfolio responses

The two types of tightening call for different stock portfolio construction, in my view.

In today’s world:

–bond-like stocks will probably not do well.  Years of ultra-low interest rates have forced Baby  Boomers to search for income in the stock market.  As rates rise, and bonds become increasingly attractive, some Baby Boom money will return to bonds.  At first, the reverse flow may only be new money.  At some point, however, Boomers may begin to liquidate their income stocks.

–rising rates may make the dollar spike.  In fact, the IMF recently expressed this fear in an emphatic plea to the Fed to postpone the start of the rate normalization process into 2016.  It’s not clear to me that the dollar will appreciate much further, however.  But if it does, stocks with foreign exposure will become less attractive, since the dollar value of their foreign earning power declines.  On the other hand, foreign companies with large US exposure become more attractive, both to local investors and to you and me.

–companies with their own special growth story become more attractive than those that are mostly dependent on the general business cycle for their oomph.  Cloud computing and Millennial favorites should be relatively fertile fields.  Arguably, the market’s preference for growth stocks over value has been in place for some time.  But the preference for the former should intensify.

 

More tomorrow.