INVESTING IN GROWTH STOCKS

INVESTING IN GROWTH STOCKS

The Growth Investor seeks to profit by investing in companies that are growing at rates above the normal rates of growth in the economy or in an industry. This article looks at two basic approaches to investing in growth stocks: Fundamental and Relative Value. Lastly a broad set of rules is presented which should assist the Growth Investor.

FUNDAMENTAL APPROACH TO GROWTH STOCK VALUATION – THE DDM

The Dividend Discount Model (“DDM”) is a conservative model that attributes a value to a company based on its discounted future dividends. As the market price rises relative to the fundamentals the DDM will find fewer and fewer undervalued companies, which can be viewed as either a strength or a weakness if the market remains at historically high levels.

The basic valuation model is called the Gordon’s Growth Model and it is calculated as follows:
Value of Stock = D1/(r-g), where D1 = the dividend next year, r = the required rate of return for the equity investor, g = the growth rate of dividends in perpetuity.

The DDM is a simple model, which works quite well, when the dividends are growing at a “stable rate”. The difficultly is to find an appropriate and “stable rate” of growth for the future. In theory a firm cannot grow at a faster rate than the economy forever, so it can be assumed that a firm with a stable growth rate is one whose growth rate does not exceed expected inflation plus the expected real growth rate of the economy.

The deficits of the Gordon Growth Model are its extreme sensitivity to the growth rate used. Furthermore, it does not effectively reflect the various stages of growth through which businesses go. For this purpose Multi-Phase DDM models were developed. The Classical 2 Stage DDM Model incorporates a phase of extraordinary growth and then a subsequently phase of stable growth, whereas the “H model”, which is also a 2 stage model, has an initial growth phase, which declines linearly through time. Lastly there is the 3 stage model which has a High Growth, a Declining Growth and a Stable Growth phase. All these models help the Growth Investor to find those companies that can sustain above-average growth in a competitive economy.

Past growth rates are often used to predict future growth rates, although Little’s study (1960) showed sequential earnings growth rates having little correlation. Nevertheless, evidence suggests that companies with little variation in their earnings in the past will have more predictable growth rates in the future. In my own screening tools I favor Growth Stocks with less volatility in earnings over the previous 5 years. Furthermore, the size of the firm is a factor inversely correlated with its growth rate. However, investors must also be careful using historic Growth rates for cyclical firms, where the trend is calculated for a period shorter than one business cycle. Changes in business fundamentals or regulation also mean that past growth rates cannot be used. Finally the quality of earnings growth may change due to acquisitions or accounting.

Caution is necessary in using analysts’ forecasts to predict growth, as the quality of their forecasts deteriorates over time. Consensus numbers should also be not used blindly, although the secret of predicting growth rates may lie in discovering inconsistencies between analysts’ forecasts.

Another measure of growth that I use in selecting Growth Stocks is the Return on Equity (“ROE). Academics have empirically linked this ratio to stock outperformance. Theoretically, the ROE multiplied by the “1-dividend payout ratio” should equate to the growth rate of future earnings and many Growth Investors will not invest in stocks unless they have ROEs of at least 20%.

RELATIVE APPROACH TO GROWTH STOCKS– THE PEG RATIO

In his book “The Zulu Principle” (1992), Jim Slater advocates the use of a PE/Growth screening process, or PEG ratio, to identify securities which are undervalued in relation to their prospective growth rate. To an extent Slater is using Ben Graham’s principles of value investing with a margin of safety. Slater states: “Many people believe that the term value investing only refers to buying assets at a discount. In fact, value investing is broader than that – the essential concept is to look for values with significant margin of safety relative to share prices.”

Slater points out that when a dynamic growth company is bought on a low P/E ratio, with a consequently low PEG factor, then those growth prospects are being bought by the investor at a discount. Slater is prepared to buy stocks at higher P/E ratios than Graham, but he claims to obtain his value by linking the P/E paid to the estimated growth rate and establishing a safety net with other criteria.

The advantage of Slater’s system, compared with Graham’s fundamental strategies, or the DDM Model, is that the investor does not have to withdraw from the market until conditions are suitable. However, during periods of negative growth rates, as in the 1930s, Slater’s methodology would be largely inapplicable.

Slater’s criteria for selecting his PEG stocks are as follows:

• Growth of EPS in four of the last five years, being at least 15% compound
• A low PEG ratio of 0.75 or less, preferably under 0.66
• Optimistic Chairman’s Statement
• Borrowings limited to 50% of net assets
• A competitive advantage, evidence by a good PBT margin and ROCE
• Something new, e.g. a management shake-up or a new product
• A small market capitalization $20-200 million, but the method is also applicable to large firms
• High relative strength
• Dividend yield of 4% plus, but less if dividends are growing strongly in line with earnings
• A reasonable asset position
• Some management share holding – ideally 20%

A similar PEG strategy, tested by Peters (1991), showed the top decile achieving a return of 1536%, beating a 356% return on the S&P 500. However, the sample studied was only from 1982 to 1989.

RULES FOR INVESTING IN GROWTH STOCKS

You should see the investment as an investment in the individual business. Do your own research on the company and get to know the business well. Furthermore, try to do your own valuation of forward growth expectations.

Growth stocks offer potential hefty gains and losses. The objective is to find tomorrow’s winners. The Growth investor must ignore the myths that the profits are higher in fast growing industries. It is also worth remembering that every blue chip growth company will ultimately mature.

Earnings are what count, not empty promises. You are looking for above-average EPS over the last 5 years (minimum 3 years) and to buy the stock at a reasonable price. The potential double benefit comes from growing earnings and expanding P/E multiple after broker upgrades.

For non-seasonal businesses you need to focus on consecutive quarterly sales to derive the most up to date growth rate. For Retailers you may need to focus on year-over-year quarterly growth.

Historic prices are not important, so do not be drawn in by rising stock prices. The investor should rather concentrate on P/E relative to growth, or P/E relative to historic P/E ranges. A company that consistently beats estimates is probably cheaper than the P/E suggests as the prospective Earnings may be understated. Lastly, try to avoid highly visible companies with high P/Es. In times of pessimism growth will be understated and in times of optimism growth overstated.

The growth must come from a “sustained” demand for the products or services of the company and not a “temporary” cyclical factor, e.g. construction booms. Competitors must also not be able to enter the market easily and take market share.

The type of industry is not critical. More important is sales growth and a corresponding profits or EPS growth. Falling margins are not good, whereas increasing profitability is an indicator of long-term success. If the Price/Sales ratio is over 5, then the company must have excellent growth and margins. If the P/Sales ratio is under 1, then more modest growth and lower margins are acceptable.

Carefully review the balance sheet to examine why the firm is growing so fast. The profit growth may just come from a large increase in inventories. Read the notes to the accounts to identify extraordinary items or future problems.

Diversify your portfolio. This is very important as the prices of individual stocks in the portfolio will be very volatile. Holding some cash as part of the portfolio is a good idea, as there will be opportunities to take advantage of exaggerated price falls in stocks you would like to add to the portfolio.

If the P/E ratio, the P/S ratio, trends and future growth prospects for products and services look excellent, but the Relative Strength Indicator of the price over the last 12 months is low then do not buy, as something is probably wrong. Watch what insiders are doing! Directors’ Buying may be a good indication.

SPECIFIC RULES FOR INVESTING IN TECHNOLOGY STOCKS

The best technology does not always win and do not be fooled by technology that sounds too good to be true, even if a few Big Names take investment stakes. What the customers say about the technology or the company can be decisive, so Trade Fairs like CEBIT in Germany can be useful. If a firm does have a winning product then product protection or a strong brand name are important. Ideally you want to find companies which have products in growing markets; with a growing market-share; and which are creating new products and markets. It never ceases to amaze me how analysts are jubilant when companies announce they are increasing their market share in a declining market. This is normally the road to ruin. Technology Investors should look for profitable companies, which are not mature and have a dominant share of a high-growth market.

Operating leverage is excessive in software companies. After deducting fixed costs for people, marketing and offices, the money will flow straight to the bottom line, with less than 5% needed for the costs of goods sold. Therefore in good times Software companies can have high P/Es. However, operating leverage works against companies in bad times.

Set a minimum target for revenue, e.g. $50-100 million. Look for revenue growth of 20-25% over the last three years. You should use Forward Earnings for Technology companies as the numbers can change quickly. Where there are no earnings and therefore no P/E, then use the Price/Sales ratio. For technology companies you can also use the Price to Research Ratio (PRR). This should be less than 5 times, especially in recovery situations.

An RSI technical indicator of 10 to 20 weeks is favored for Technology Growth stocks, whether for recovery or the long term, however, the RSI is meaningless for small cap stocks, or those which do not have a liquid market in their stocks.

Software companies get severely punished when they miss numbers and can fall 50% in an instant (“gapping down”). This may often be due to a delay, as opposed to cancellation, of orders. A Growth Investor with a 12 month time horizon can do very well, if he is convinced that the company is of an adequate size, has a good brand and has sufficient execution skills. After a series of earnings disappointments share prices will fail to price in a recovery. This can present an opportunity, if the company has enough cash in its balance sheet to cover foreseeable R&D costs. You do not want to have to perpetually finance rights issues.

Do not get emotionally attached to a share. Taking part-profits is a good strategy and setting a stop-loss to lock in profits is recommended. Although I do agree with setting a stop-loss of 15% to 20% for most shares, this may not be appropriate to fresh investments. Furthermore, the reaction of Technology stocks to news flow can be very volatile, with 5-15% moves in a single day non being uncommon. Therefore a “simple” Stop-Loss policy must be used with caution.

The management and staff of a Technology company are critical, so the track record of new management is a good indicator. New management will often enjoy a period of grace during which the share price may rise. CEOs do not have to be under 50 years of age, but I am concerned, where I see that the management are stale or are about to retire. Good people remain the key to the execution of a successful software business, so if they go then the business is over. Be careful if the story told by management is “too good”; if they claim to be immune to the pressures faced by their peers; or if they refuse to answer questions from short sellers. Beware excessive related party transactions and check that EPS numbers reflect the potential dilution of executive share option schemes.

CONCLUSION
My intention in this article is not only to give an overview to the Fundamental and Relative Value approach to Growth Investing, but to also present various rules and guidance to becoming a successful Growth Investor. The investable universe is large, with many companies out there, which are not frequently researched and which consequently may offer exceptional gains and having some fun in the process.