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?
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.
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.
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):
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.
- Specifically: 5 x 12.76p = 64p [↩]