Growth Investing

On 09/13/2010, in Investment Strategies, by Jordan Wilson

Following a growth strategy is another common method of investing in equities. You will also see many mutual funds that utilize this style.

Today we will take a look at growth investing.

What it is. How it compares to value investing. And some areas to watch out for when trading in growth stocks.

Some investors believe that a growth strategy is the polar opposite of value investing. I would not fully agree with that assessment. There are differences, but there is also some common ground between value and growth strategies.

Growth Companies

Growth companies are those whose future earnings are expected to grow at a higher than average rate as compared to specified benchmarks. The benchmarks may relate to the stock market as a whole, or to the industry or sector in which the company operates.

Companies expected to have strong earnings growth typically pay out little to nothing in dividends to shareholders. These companies reinvest their earnings and cash flow into the company, so as to continue growing the business.

As we saw with value investing, many analysts review price-to-earnings (P/E) ratios to assess where a stock might trade. If the earnings are rapidly growing, that suggests upward price movement in the stock, assuming the P/E multiples remain constant.

Growth Strategy

In value investing, investors look for companies with relatively low P/E and price-to-book (P/B) ratios, as well as high dividend yields.

In growth investing, this same fundamental analysis is less important.

Growth stocks may have low price-to-earnings or price-to-book ratios. Or, more typically, the ratios are relatively high. This reflects the belief that growth stocks will increase their earnings over time, thereby justifying higher multiples.

Individuals invest in growth stocks for the capital appreciation potential, not for dividend income. As a result, dividend yields are not heavily considered. Except to the point that growth investors prefer companies that reinvest earnings into the company, not pay them out to shareholders in dividends.

Because of the desire for capital gains over an income stream, growth investors have a higher risk appetite than value investors.

Quantitative Analysis

The key is the expected earnings growth, rather than any specific ratios.

In analyzing the numbers, investors look at three areas.

Historic Revenue and Earnings Growth Rates

Revenues drive earnings. Without sales growth, earnings will suffer.

Earnings result from revenues. But they are also impacted by a company’s cost structure.

Revenues may increase, but if a company cannot manage its expenses, then earnings will not increase as expected.

When assessing earnings potential, it is imperative to consider costs, not simply revenues.

Some analysts believe one should look for companies that have experienced a minimum of 10% average annual growth in both revenues and earnings over the previous 3-5 years.

Others believe that 15% is more appropriate, with a 20% growth rate for the most recent year.

Rather than engage in absolutes, I prefer to compare a company’s metrics against competitors, industry, and the market as a whole.

Perhaps the biotech industry earnings are growing at a rate of 50% per annum. Would I consider any biotech companies growing at 30% as growth stocks? Probably not.

When looking at numbers, always put them in context.

Future Revenues and Earnings Growth Rates

As with any quantitative analysis, the past is interesting, but the future is what counts.

Investors must analyze potential growth rates for revenues and earnings over future periods.

For many companies, professional analysts and the companies themselves provide estimates for future results.

Of course, the future is based on many variables that may or may not come to pass.

And the farther out the time period,  the less reliable the estimates.

PEG Ratio

One ratio that growth investors do often use is the price-to-earnings-to-growth (PEG) ratio.

It takes a company’s P/E ratio and divides it by the company’s annual earnings growth rate. The lower the ratio, the potentially more attractive the stock.

Stocks with ratios less than 1.0 are considered undervalued.

Some investors prefer the PEG over the P/E alone as it factors in growth rates, not simply static earnings.

Consider two companies. A has a share price of $100, earnings per share of $2.00 and an expected annual earnings growth rate of 25%. B has a share price of $15, earnings per share of $1.00 and earnings growth of 10%.

With greater earnings and higher growth rate, A might be the better stock.

But if we look at the ratios, we see that A has a P/E of 50 and a PEG of 2. B has a P/E of 15 and a PEG of 1.5.

In comparing P/E ratios between A and B, it is hard to come up with an assessment of value. The lower P/E of B indicates it might have value versus A. But without knowing the industries in which the companies operate (and the industry average P/Es), it is difficult to make any sense of the ratios.

By factoring in the earnings growth rates, comparisons can be made.

With a lower PEG ratio, B appears to be the better investment. A may have higher earnings per share and better expected growth, but it appears to be overpriced relative to B.

Qualitative Analysis

In assessing growth stocks, qualitative analysis is extremely important.

In this sense, growth analysis is very much the same as value investing.

When determining the potential for growth, investors seek companies that they believe will dominate their industry or sector. Companies that will experience revenue and earnings growth that is superior to its competitors or the market.

Companies that dominate tend to have at least one significant competitive advantage.

This may include: patents, new technology, etc. that provides a product or service advantage; superior management that provides the leadership to excel; possessing substantial barriers to entry that prevent competitors from entering the industry, thus creating a monopoly or oligopoly that can be exploited; marketing campaigns that enhance sales; superior production or delivery methods that reduce costs versus competitors.

Microsoft, Dell, Apple, and Google have all been growth stocks. If you look at their developmental years, you can see how they used different competitive advantages to rapidly increase revenues and earnings.

Each of these companies has many reasons for their rapid growth. But if we pull one reason from each, we see some of the above characteristics.

With Dell, it was a superior delivery method for personal computers. Apple had a visionary leader in Steve Jobs. Google developed a new method to search the internet. Microsoft rose to dominance with their proprietary operating systems.

I could list many other examples of companies with competitive advantages. I am sure you can think of many as well.

Assessing the futures earnings potential requires more qualitative analysis than quantitative.

Problems with Growth Stock Analysis

Growth strategies are based on investing in stocks with relatively high earnings growth.

But in assessing earnings growth, one must make assumptions concerning multiple variables. As with any estimates of future results, there are many variables that need to come true. If any of the assumptions are incorrect, the resulting earnings projections will be wrong.

Second, the farther out the time horizon, the less reliable any estimates can be.

These are common problems with all quantitative analysis under any investment style.

Third, what exactly is relatively high earnings growth differs between investors. As we saw above, some analysts believe 10% growth to be high. Others 15%. And there are no doubt some investors that have higher thresholds.

How you define a high growth rate will frame your investment options.

Fourth, many growth stocks are relatively small companies; small to mid-cap in size. Therefore, public information may be limited, making quantitative analysis more difficult.

As companies grow in size, it becomes harder to maintain above average growth rates.

You can see this in the results of many former growth stocks. Over time, as they grow, earnings growth falls within normal parameters.

For example, Google, a classic growth stock, has an average estimated earnings per share of $27.26 for the year ending December, 2010. For 2011, the estimate is $31.33. This equates to annual growth of 14.9%.

Microsoft has estimates of $2.36 for 2010 and $2.64 for 2011. An increase of only 11.9%.

In both cases, the growth rates for these two companies would be too low for many investors.

While there are differences between value and growth styles, they do have commonalities.

Both rely on quantitative analysis that is based on assumptions that may or may not be accurate. The worse the assumptions, the greater the probability of poor investment selections.

And both styles rely heavily on qualitative assessments. This requires an understanding of the company and the industry in which it operates.

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