The dream of a growth investor is to discover the next Apple or Coca-Cola just as it’s getting started.

One or two such investments can make your fortune. Exactly how to find them is the $6 million question!

In the blue corner, we have the efficient market theorists who say it’s a doomed endeavor, and that you’re better off putting money into an index fund.

Most money managers fail to beat the market. What hope have you got?

In the red corner, we have investing legends like Peter Lynch, Jim Slater, and Philip Fisher, who did beat the market through growth investing and who outlined how in various books.

As always I’d suggest most people should stick to passive investing. Despite what the financial industry tries to tell us, you don’t need to risk picking shares or to invest in expensive managed funds in order to achieve what you need to from investing.

However for those of us who do find stock picking irresistible, growth can be especially enticing – despite the steep odds against success.

Today’s great growth companies are tomorrow’s global giants

There’s little doubt that growth investing is statistically even less likely to beat the market than value investing. Value at least has some evidence of market beating metrics on its side.

Weighing up a growth company is hard – and it’s even harder if the company isn’t yet making much profit.

However that’s not sufficient reason alone to deride a young growth company as “insanely overvalued” or even “worthless”, as commentators are wont to do.

Investing in such a company may well be incredibly risky and it may well look seriously expensive. That might make a share uninvestable for you. And the truth is most growth stocks would be best avoided, as the majority fizzle out long before they deliver on their promise.

Nevertheless all giant companies began life as small ventures, and most of them started without profits.

With hindsight, we can see that far from worthless they were actually bargains for much of their existence, and they could have made us rich – if only we’d been able to tell the very few winners from the many pretenders along the way.

Growth investing is all about the future

The number one thing to grasp about growth investing is that it’s about looking forwards, not backwards.

Whereas a traditional value investor tries to pay a low price for today’s assets and cash flows – and usually demands a discount to be safe – a growth investor aims to pay a fair price for cash flows that he or she expects to come in the future.

Because the future is unknowable, this involves a fair bit of guesswork and heuristics, which is one reason why growth investors sound much woolier than value investors.

To my mind the important aspects of growth investing include:

• Deciding on the 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. Growth investors particularly like first movers who look capable of dominating their space.

• Understanding the business – Value investing in its purest form is just about the numbers. Growth investors must understand the business opportunity if they’re to evaluate its long-term potential, its progress, and how much other investors are paying for an entry ticket.

• Small size, massive opportunity – “Elephants don’t gallop”, said Jim Slater. Microsoft is a fine company – perhaps it will double in size in the next few years – but with a market cap of over $320 billion it’s not going to become ten times bigger anytime soon. But a £25 million company can double in size every year or so, provided its opportunity is big enough to sustain its growth.

• Disruptive company – Often (but not always) an excellent growth company is doing something new, which changes an entire market. Think Google in the early years or McDonalds with its franchise-based approach to restaurants, or Tesla and its premium electric cars.

• Great leadership – New companies are much less stable than mature ones, and that’s especially true in new or fast-changing sectors. Many people could have a stab at running M&S and achieve okay results for shareholders. Very few could do the same at Amazon.

• Stellar sales growth – Surging sales validates the growth opportunity, provides cashflow for reinvestment, and in time enables a good company to overcome its ongoing expenses and capital expenditures to generate a profit. Think 20-50% annual sales growth over more than several years.

• Gross operating margin – A very high gross margin tells you that a company doesn’t have to spend much to create the product its customers consume. What’s high varies by sector – Twitter has very different input costs to Tesla – but as a rule, a high gross margin can give you more confidence that your growth company will at some point achieve escape velocity.

• An emphasis on expectations – Growth investors are much more reliant on analyst’s forecasts than value investors, and will treat profit forecasts 2-3 years into the future as credible. This is inherently risky.

• High return on capital employed – It’s easy to grow by issuing lots of shares to expand, or by taking on more and more debt. Good growth companies make money for shareholders.

On the other hand, growth investors don’t much care about:

• P/E ratios – These can be sky-high for young companies, but that doesn’t mean the companies are a crock. If a company has a massive opportunity to grow sales and future cashflows, it makes sense for it to reinvest most or all of the cash generated back into the business before any earnings hit the bottom line. Look at sales growth and gross margins instead, and check where the company is spending to see if it’s investing for the future.

• Re-ratings – Usually when I invest I want to discover an unpopular share on a low-ish P/E that gets re-rated to a higher P/E when perception changes. Such a re-rating hugely increases the gains from any underlying earnings growth. But great growth companies are seldom cheap on this basis, and if they are then something may have gone wrong with the story. I know of growth investors who for this reason only buy expensive shares!

• Dividends and buybacks – Most growth companies need all the cash they can get to recruit staff, build more capacity, push into new markets, promote their products, and so on. It makes no sense for a company capable of compounding money at 20% or more a year to return capital to shareholders.

Don’t be fooled! Many small cap companies look like growth stocks now and then, but the growth soon moderates. Any manager worth his salt can spin a good story. Cyclical companies grow for a few years but then sales plunge. Most companies with small profits and large outlays are probably just bad investments, as opposed to laying the foundations of a mighty empire.

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, too. It’s hard to turn a small company built around a charismatic entrepreneur into even a medium-sized one 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.

No company can grow forever – even Apple seems to have run out of road. Any let up in growth will be punished hard if the shares are highly-rated.

Growth, value or both?

Having started my investing life as a strict value investor, I’ve become a bit more interested in growth over the years.

Perhaps it’s because the market has typically been pretty richly priced – 2008-2010 aside – so the value opportunities have often been in especially awful 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.

Buffett doesn’t subscribe to the pure definition of growth investing, saying growth and value are two sides of the same coin.

And that’s about where my investing philosophy is, too. I can rarely bring myself to pay for shares on sky-high P/E ratios, let alone loss-making companies promising “jam tomorrow”. I will defend them, but it’s hard to invest in them.

Still, all things being equal I’d prefer to buy a decent business growing at 15-20% a year at a fair price than a low P/E business that’s stagnant but cheap.

This sets me against the UK investing great Antony Bolton. In a review of Bolton’s Investing Against the Tide, Richard Beddard quotes Bolton as saying:

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.

Bolton is a value investor through and through, and I think he’s more mindful of risk here, as opposed to maximizing his potential return.

Low P/E companies are (if you know what you’re doing) far less risky than high P/E companies, because there’s not much hope baked into their price.

But risk aside, there is a strong logic to betting on growth, which is that fast-growing companies can deliver stronger returns due to the power of compounding.

Let’s consider a made-up company, Go-Go Growth PLC, in that range of scenarios outlined by Bolton.

We’ll assume GOGO is currently earning 10p per share.

The following table shows us what will happen to GOGO share price in Bolton’s scenarios after five years, under three different earnings growth scenarios (i.e. 5, 10, and 20% growth):

P/E	Initial price	5%	10%	20%
5	50p	64p	81p	124p
10	100p	128p	161p	249p
20	200p	255p	322p	498p

Note: Author’s calculations.

The three prices in bold (64p, 161p, and 498p) are the important ones to look at first. These show us where the share price would be after five years if the P/E multiples remained unchanged.

You can see that after five years, Bolton’s 5% grower on a P/E of 5 would be worth 64p, after its 10p per share earnings grew to just under 13p1. That’s a share price return of 28%.

In contrast, the P/E 10 share growing at 10% has risen to 161p for a gain of 61%, and the 20% grower has delivered a gain of 149%!

The faster the earnings growth, the higher the final return. Clearly, if all things stay equal it’s far better to own a fast-growing share, even if you have to pay a high price to get started.

Run this scenario over 10 years and the gains become even more divergent.

The P/E 5 share growing at 5% will be up 62% after 10 years, but the P/E 20 share growing at 20% will have delivered a gain of 519%.

But all things do not usually remain equal

In reality, you could invest for many years and never manage to find and hold one company that grows consistently at 20% a year for 10 years.

Certainly they are out there and they are easy to spot in hindsight. But they are not so easy to find in advance of their gains, even using the growth investor mindset I outlined above.

Much more commonly your 20% grower becomes a 10% grower, or worse. I have previously written about how such a change will rightly cause investors to reduce the P/E multiple on the shares. Such a ‘de-rating’ can devastate your returns.

Look again at the table above. In it we see that the P/E 20 company that grows at 10% a year for five years and remains on a P/E of 20 at the end of that period would be priced at 322p.

That’s a gain of 61%. Not a champagne moment for a growth investor, but probably better than cash in the bank.

However in reality investors would probably reduce the P/E closer to 10 for that 10% growth. In this case earnings will have grown to a little over 16p after five years of 10% growth, and on a P/E of 10 would imply a price of 161p.

Remember, you initially paid 200p! This means you’ve made a 19.5% loss as an investor, even though your company grew earnings at 60%.

That’s the risk of growth investing in a nutshell.

On the other hand, what if you were Bolton and you bought the 5% grower on a P/E of 5, but it actually grew at 10% a year?

Again, earnings have expanded by 60%. That surprises the market and makes the shares look cheap, even if their price kept pace to grow to 64p.

Investors might decide that 10% was the new likely sustainable growth rate for the company, and they might now pay a P/E 10 multiple for the shares.

In this scenario canny Bolton has benefited from buying cheap. At P/E 10 the shares are priced at 161p.

Remember, the cheap P/E 5 shares started at 50p, so that’s a 222% gain!

There are no rules about P/E ratios. Don’t imagine that 10% earnings growth should always command a P/E multiple of 10 or anything like that. These are just rules of thumb and convenient examples. In a bullish market P/E multiples will expand, and in a bear market they will contract. Companies also have their own bull and bear markets. At the end of the day, the P/E rating will also incorporate factors like confidence about management, the business franchise, the prospects, and many more. Debt is a massive factor, too, which is why you may need to look at enterprise values and EBITDA if you become a growth investor.

So is it best to play safe or to go gangbusters for growth?

Obviously there is no certain answer – if there was we wouldn’t be urging most people to employ passive investing strategies every week… 😉

At the end of the day it comes down to temperament. I think the best reason to be an active investor (perhaps the only good one) is because you enjoy it. Doing something you find agreeable is a more certain pay-off than the prospect of beating the market.

Some who are drawn to active investing will love looking to the bright shiny future promised by growth companies, and some are curmudgeons and tyre kickers who love bargains and will take to value.

To thine own self be true!

Note: I know I said this next growth investing post would be about valuing “worthless” growth companies. I still mean to get to that, but I got bogged down in complicated spreadsheets and want to present it as simply as I can. Watch this space.

1. Specifically: 5 x 12.76p = 64p [↩]

Good reads from around the Web.

A late start for me today, after a too-late night at the sort of London wine bar that I fantasized about and at the same time derided when I left the provinces 20+ years ago, and where a friend actually said “Fashion is dead” with a straight face as if it were the 1980s.

The shame. Get thee to a Wetherspoons!

[continue reading…]

Unlike most value investors, I don’t say three Hail Marys and reach for the smelling salts when I come across an attractive-looking growth stock.

I’m a pretty mongrel active investor, and will consider almost anything if the price looks right.

Besides, I admire growth companies.

These are the dynamic outfits that are inventing the future. And regular readers will know I believe that the future is getting brighter every year (the woeful exception of the environment and my worries about inequality aside).

Solar power, 3D printing, wearable technology, genome therapy, cars made from graphene – bring it all on!

But as a rule I won’t be investing in it.

Growth investors aren’t usually rewarded

I applaud those few investors who through skill or luck beat the market over several decades by identifying the best growth prospects.

It must be amazing when a share you own climbs 100-fold over 25 years, as happened with those who backed Amazon after its IPO, for example.

That’s not going to happen when you invest in a popular defensive company like Unilever or GlaxoSmithKline, whatever other virtues it might posses.

The snag with growth investing is that the Amazons of the world are rare.

Even when you do identify a successful company, there’s a big difference between noticing it’s making brilliant products that could change the world, and investing in it for market-beating returns.

Indeed most stock pickers who focus on growth1 do much worse than value investors when it comes to beating the market.

They would be better off in passive index funds, like the vast majority of people.

If they must be active investors, then it’s value, quality, and small size that have a track record of delivering alpha.

The academic research suggests a basket of growth shares will underperform.

Incidentally momentum – the tendency for winning shares to keep winning – is the other premium that has been shown to beat the market, and often it’s associated with growth stocks.

But over time momentum shifts from one sector to another.

And when a growth sector falls out of favour, it falls hard!

At least technology investors get to read about science-fiction gadgets while they’re busy losing to the market.

Growth feels good

Actually that’s a real reason why growth investors tend to do worse than value investors.

It feels great to own shares in a sexy electric car manufacturer, a biotech startup that could cure cancer, or a social media site that all your friends use.

A cluttered Facebook feed is still annoying if you’re a shareholder, but at least it’s making you money…

Compare owning shares in super-cool electric car maker Tesla with owning shares in a miserable metal basher in Northern England, a miner facing legal problems, or a liquidating investment firm that’s losing clients.

All the latter have been profitable trades for me over the years, but these value shares not what anyone wants to hear about at those mythical cocktail parties.

Because it feels great to own growth shares, people will pay too much to do so, and then spend their days daydreaming about the tech revolution while reading glowing earnings reports.

Growth investors also over-estimate their chances of finding the next Amazon – which means that so-called lottery ticket stocks as a group become too expensive, due to people bidding up the price of entry.

Good but not great enough

The market is not stupid, and it does a pretty good job of identifying companies with excellent growth prospects.

Many highly rated fast-growers do indeed go on to achieve great things – including massively higher sales and profits.

But investors in aggregate pay too much to get on-board. As a result, their investment doesn’t do anything like as well as the company does.

A classic example of this is Microsoft.

People talk about how Microsoft lost its way after the dotcom crash in 2000, and it’s easy to get that impression if you only look at the share price:

• Between the 1 January 2000 and the 1 January 2013, Microsoft’s share price declined by over 50%2.

• Over the same period the wider S&P 500 index was basically flat.

That does indeed sound terrible – and it certainly was if you bought Microsoft shares on 1 January 2000:

Losing money over 13 years is no path to retiring early, let alone retiring rich.

But Microsoft didn’t become a terrible business over that time. Far from it.

Over that long period of share price decline, Microsoft grew both sales and profits as it milked its dominant market position:

• In the year to June 2000, Microsoft’s total sales were $23 billion. Net income was $9.4 billion, and earnings per share was $0.91.

• In the year to June 2013, total sales were $78 billion. Net income was $22 billion. Earnings per share was $2.61.

Sales tripled over that ‘miserable’ 13-year period, profits more than doubled, and earnings per share rose by 186%.

Good progress through a tough economic period, yet an investor who bought Microsoft shares at the start would have been better off if she’d just stuffed her money under the mattress.

Higher P/E multiples, lower returns

Microsoft had decent prospects in the year 2000, and the market knew it.

Unfortunately investors paid too much to own a piece of the action.

The resultant growth was good – but not that good – so they suffered when their shares were de-rated over the next decade or so.

• In 2000 Microsoft’s average price-to-earnings multiple peaked near 50.

• In the 12 months to 2013, the P/E averaged around 15.

Even as Microsoft’s profits grew, investors paid a lower and lower multiple for the shares – mainly because the rate of growth was decelerating – which put a lid on the share price.

If the P/E had stayed roughly constant during the period, then the shares would have cost you well over $100 by June 2013.

But reality, they changed hands for more like $35.

Growing up dis-growth-fully

The morale? Pay too much for your growth shares, and you’ll pay a high price in terms of poor returns.

By 2013 Microsoft’s share price had fallen enough to make it attractive to another sort of investor, who was buying into the current earnings and quality of the business and the dividends thrown off by its prodigious cashflow.

The ‘discovery’ of Microsoft by this new kind of investor (combined with a massive bull market) saw the share price recover and rise nearly 30% in the 12 months to May 2014.

You can arguably see a similar transition in Apple’s share price, as it has seemingly become ‘ex-growth’ and abandoned by its original investors, and then gotten bid up again by attracting a different kind of shareholder due to its higher dividends and share buybacks.

It’s tough to make predictions, especially about the future

It’s easy with the benefit of hindsight to see that Microsoft shares were too expensive in the year 2000.

The annual growth in earnings per share since then has been just under 10% a year. That’s okay – the market might be expected to do GDP growth plus inflation plus dividends – but it’s not what made Microsoft into Microsoft.

Remember, some investors in 2000 paid a P/E multiple of 50 or more for what turned out to be 10% a year growth.

They look like idiots.

Yet it’s very difficult to judge how quickly a fast-growing company will expand when you’re looking at at a history of rapidly escalating earnings as well as big prospects ahead of it.

And anyone who has played with a compound interest calculator knows how differences of a few percentage points really add up.

So let’s have some empathy for those Microsoft buyers of yesteryear.

Investing in Microsoft’s might-have-been

Up until the year 2000, Microsoft had been growing earnings at a fearsome rate.

The average annual growth rate in earnings between 1996 and 2000 was 42.5%!

Consider an investor who evaluated Microsoft’s position in the PC world, decided it looked unassailable – which it did in 20003 – and pondered buying the stock.

Let’s imagine our investor decided Microsoft’s earning’s growth would more than halve over the next 10 years or so, to just 20% a year.

Halving the growth rate seems prudent enough. PC sales were booming in 2000, Apple was tiny and smartphones and tablets not in the picture, yet it was obvious everyone and their granny would soon be on the Internet. The emerging markets were rapidly getting connected, too.

Well, if earnings had grown at 20% for the 13-year period we looked at earlier, then in 2013 Microsoft would have posted earnings per share of around $9, as opposed to $2.61!

What would that have been worth in terms of the share price?

I don’t know, but I’m pretty confident the shares would have done a lot better than the minus 50% they did achieve.

As a ballpark guess, I suspect after such a run Microsoft shares would have sat on a P/E multiple of at least 20, if not 25.

The share price might therefore have been between $180 and $225 – as opposed to the $27 it actually hit in 2013 after its steep P/E de-rating and much more ordinary growth rate.

A big market and a moat is not enough

Microsoft is an interesting growth-investing-gone-wrong case study for many reasons:

• It challenges you to remove your hindsight bias and remember just how strong Microsoft looked in 2000.

•  It was already very profitable with a wide business moat, so this isn’t a blue-sky tech stock that’s near impossible to value.

• Microsoft tripled its sales and has become a far bigger company over the period. It’s been a success!

• It hasn’t crashed and burned.

• It was nevertheless a poor investment for most of the past 13 years.

Some growth investors would argue they’d have bought Microsoft long before 2000, when it was much smaller and with more potential ahead of it.

And for some that’s probably true. Large size definitely works against growth investors.

Yet the fact is many did buy Microsoft on a sky-high P/E rating – the share price wouldn’t have got so high otherwise!

Others might claim they’d have dumped the shares when it became obvious the growth was slowing.

And many did – eventually.

Yet the Microsoft story does highlight the difficulties of growth investing.

It’s only in looking back that we can see that Microsoft was doomed to move from a high growth multiple to a more typical rating of a US blue chip. If you’d started arguing its best days were behind it too early in 1998, you’d have looked pretty silly when earnings swiftly doubled again in just two years.

For these reasons and others, I don’t usually buy expensive growth shares. When I do, I don’t tend to hold them for long.

Yet holding on is invariably part of any successful growth investing strategy.

Grabbing them by the glitches

I’m a value investor at heart, even when I buy into a sexy growth share.

So usually I’ll only make such a buy when there’s been some sort of ‘glitch’, to steal a phrase from Free Capital, the excellent book about private investors.

Glitches might include:

• A profit warning where the market seems to overreact.

• A general problem in its sector that I judge can be overcome.

• Some sort of delay in sales that I think is just a timing issue.

• Market sentiment changing (the most common reason).

The glitch hits the share price, lowers the P/E rating, and to my mind buys me a margin of safety.

I’ll usually sell as soon as I’ve got some profits in the bag.

This is a big contrast to true growth investors, who prefer to buy companies when the price is marching higher.

A higher share price vindicates their take on the company’s future. Also you will never benefit from a 100-bagger like Amazon if you take profits when the price rises a mere 30%. Growth investors need the big winners to make up for their many also-rans.

In fact, most growth investors see glitches as early warning signs that the growth story might be over – and as we’ve seen with Microsoft they are often right to.

Nothing is easy in active investing. Ignore anyone who says otherwise.

What about the worthless?

I’ve not managed to fully hold onto any growth shares I’ve bought in my investing career, though I do still have a couple of top-sliced holdings that have gone up three or four times since I bought them.

Real growth investing is too hard for me to be confident about – and that’s before we get into the difficulty of valuing companies that aren’t yet reporting profits.

Again, I’m not one of those value investors who spits at the very thought of paying up for a company that makes no money, or who says they’re all “worthless”, to quote a well-known UK investor I read the other day.

That’s silly. Nearly all companies start off without profits, and they don’t shift from being worthless to valuable the day the bottom line turns black.

Explaining why will take a whole new post, so we’ll save investing in the really speculative growth stocks for next week.

1. As defined by relatively high price-to-book ratios or P/E ratings. [↩]
2. Excluding dividends [↩]
3. Remember, this was before Apple’s revival, when Steve Jobs seemed to have returned to the company just to make Macs that looked like igloos the colour of crayons, and pretty much before ‘the Cloud’ became a thing. [↩]