The dream of a growth investor is to discover a Microsoft or a Coke in the early years. One or two such investments can make your fortune.
Exactly how to do this is the $6 million question!
In the blue corner, we have the efficient market experts who say it’s a doomed mission, and that you’re better off putting money into an index tracking fund than trying to find a needle in a needle factory.
In the red corner, we have share gurus like Peter Lynch, Jim Slater and Philip Fisher, who all beat the market through growth investing and outlined their ideas on growth investing in various books.
In my opinion, some of the important aspects of growth investing include:
- Looking for a story – Most good growth stocks have a narrative that captures the imagination as well as guiding profit expansion. It might be anything from revolutionary computer software to a new take on fast food, but it must underwrite the investing case and evolve as the company grows.
- Understanding the business – Value investing in its purest form is just about the numbers. Growth investors must have a far deeper take on the business opportunity if they’re too evaluate its long-term potential, and the company’s progress towards it.
- Small size, big opportunity – “Elephants don’t gallop”, said Jim Slater. Apple might be a fine company – perhaps it will double in size in the next few years – but with a market cap of $121 billion it’s not going to become ten times bigger anytime soon. In contrast, a £25 million company can double in size every year or so, provided the market it has identified is big enough to sustain its growth.
- Disruptive company – Often (but not always) an excellent growth company is doing something new, which utterly changes an entire marketplace. Think Google in the early years, or even McDonalds with its franchise-based approach to restaurants. (Or it may just be a resource company that strikes oil!)
- An emphasis on forecasts – Growth investors are much less skeptical about analyst’s forecasts than value investors, and will look 2-3 years into the future for profit growth.
- Re-rating – You ideally want an unpopular share on a low-ish P/E which gets re-rated to a higher P/E as the growth story spreads, as this re-rating hugely increases the gain.
- High return on capital employed – Many companies can grow by issuing lots of shares to expand, or by taking on a lot of debt. Good growth make money for shareholders.
Don’t be fooled! Many small caps look like growth stocks now and then, and any manager worth his salt can spin a good story.
The skill with growth investing is to be able to sniff out the companies that can truly deliver the best of what they promise. Any let up in growth is invariably punished hard by the market.
Even if you do find a good growth stock, be aware that managing fast growth is very difficult. Companies often expand too quickly and run out of cash, or conversely they move too slowly and lose the early initiative.
There are scaling problems by the dozen, too. It’s very hard to turn a small company built around a charismatic entrepreneurial individual into even a medium-sized company with hundreds of staff, middle managers and far-flung offices without losing the magic. (I’ve been at such companies and observed the growing pains first hand).
Should your company get through all that, then there’s the difficulty of knowing when to jump off the ride.
Few companies can grow forever – even Microsoft seems to have run out of road in the past decade.
Growth, value or both?
Having started my investing life as value investor, I’ve got more interested in growth as the years have gone on.
Perhaps that’s partly been because the market has usually been pretty richly valued, so value opportunities have often been in frankly awful looking companies.
But it’s also the influence of books and articles I’ve read, particularly the shareholder letters of Warren Buffett and his various biographies (the newest official one is full of lessons about Buffett).
Buffett doesn’t subscribe to the pure definition of growth investing, saying growth and value are two sides of the same coin.
That’s where my investing philosophy is, too. I still can’t bring myself to pay for shares on sky-high P/E ratios, let alone loss-making companies promising “jam tomorrow”.
But all things being equal, I’d prefer to buy a decent looking business growing at 15-20% a year then a low P/E business that’s stagnant – at the right price.
Is this the right approach? I suspect you have to do what you’re comfortable with.
As a growth investor you’re certainly up against a headwind. Unlike with small cap value shares, there’s no data to suggest that as a group growth shares outperform.
On the other hand, some very famous growth investors clearly have!
If you’re a growth investor, let’s hear what you look for in the comments below.
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Hi Monevator. I’m enjoying your posts. I’m definitely very sceptical about growth so I’m afraid I’m unable to answer your call to arms (though I think many growth investors look for high return on assets, which is a good predictor of future returns I believe).
Some companies grow inexorably. Abcam and ASOS have made fools of me (liked the companies, couldn’t bring myself to invest in them) but I think they’re the exception and being able to spot which keep growing and which stumble is very, very difficult. There’s more certainty in value. I’m struck by a quote from Anthony Bolton, which is almost the exact opposite of one of your concluding paragraphs:
“I realise that PEG ratios are more the domain of the growth rather than the value investor but I’m afraid I can see little logic in the argument that a business at five times earnings growth at 5% a year, one at ten times earnings growing at 10% or one at 20 times earnings growing at 20%, which all have the same PEG, are equally attractive, I would go for the five times earnings growing at 5% every day.”
It’s from his new book, I first quoted it here: http://blog.iii.co.uk/investing-against-the-tide/ (scroll down the page a bit).
I’ve made the opposite journey to you. I started out a GARP guy but have gradually got more and more cynical about growth. It’s psychologically comforting because value stocks are often so dull. But then, they’re often underestimated which is what gives them such potential.
Growth investing is momentumm investing. Follow a stock that is increasing in value because it has a good story attached to it and get out before it goes pop as everyone realises that the earnings potential is never going to be realised. Very rarely one stock does actually grows to become a cash making machine but then what are the odds. Better to stick with growth stocks with momentum behind them and not get too attached to them as most are simply going to fail.
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