Growth Investing

by | Feb 7, 2018 | Investment Strategies

Growth strategy is another extremely common method for investing in equities. Many mutual funds offer this style.

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

Today we will take a look at growth investing. What it is. How it really compares to value investing.

Followed by things to watch out for when trading in growth stocks.

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. Sometimes projected versus historic earnings growth of the company itself is factored in.

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 in value investing, analysts review price-to-earnings (P/E) ratios to assess where a stock might trade. If earnings are rapidly growing, that suggests upward stock price movement, 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. More typically, the ratios will be relatively high. This reflects the belief that growth stocks will increase their earnings over time, thereby justifying higher multiples. However, high P/E and P/B ratios are more a result, not necessarily an indication, of a growth stock. I would not focus my growth strategy on stocks with high P/E or P/B ratios. Instead, focus on earnings growth projections.

Individuals invest in growth stocks for the capital appreciation, 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. You will find that growth stocks tend to have low to zero dividend yields.

Due to the desire for capital gains over 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 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 two problems with all quantitative analysis under any investment style. Having to rely on variables and guesstimates that may or may not come true. And the longer the time period, the more risk of errors.

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 many former growth stocks. Over time, as they grow, earnings growth falls within normal parameter.

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.

Value Investing

by | Dec 13, 2017 | Exchange Traded Funds, Investment Strategies, Mutual Funds

Investors often pursue investment strategies based on market capitalization.

Additionally, equities may be viewed through the prism of being either value or growth stocks.

Today we look at value investing.

What exactly is value investing? What are its advantages and potential pitfalls. Should you value invest?

Value Stocks

Stocks in this category are seen as value buys.

That is, the stock is considered undervalued based on quantitative and qualitative analysis.

The objective is to identify companies that trade below their intrinsic (i.e., “true”) value. Then purchase shares and wait patiently for the rest of the world to see what they have missed.

Companies in this category tend to be: established companies that have fallen out of favour and been beaten down in price due to poor performance, bad news, lawsuits, management changes, etc.; smaller companies that are not extensively followed by analysts and the investing public; mature companies that have minimal upside for internal growth, so they pay out their earnings in dividends rather than reinvest in the company’s operations.

Or perhaps entire industries or sectors are depressed. Look at real estate markets in the US and Canada over the last decade. At times, significant bear markets in some regions. Oil and gas is another industry that took a hit in the past few years. Nothing wrong with the companies per se, they just happened to be in a market with low oil prices.

In essence, you are attempting to buy assets that are “on-sale” due to specific circumstances. As the circumstances alleviate, the share price reverts back to its “true” price.

In theory, this is an excellent way to invest. In any other investment you make (house, art, coins, etc.) you always try to find acquisitions being sold at a discount to market value. Better to purchase your home in a down market than to buy the same property when demand is high.

Benjamin Graham and David Dodd are considered the fathers of this investment style. Warren Buffett uses this approach in a slightly modified form. Hard to argue with those investors.

I quite like value investing. But it is not an easy process.

Given the amount of publicly available data, the number of analytical tools one can use to screen stocks, and the sheer volume of investors searching for the next great value stock, it is not simple to find a hidden gem all on your own.

If you lack the time or expertise to do your own in-depth analysis, value equity funds are a good way to invest. Many are professionally managed, albeit often at a relatively high management fee. And by purchasing a number of companies that meet the value criteria, funds spread out the risk of the individual stocks.

Quantitative and Qualitative Analysis

In analyzing companies under a value approach, analysts examine an investment’s fundamentals.

Please refer to my post on Quantitative and Qualitative Analysis for details.

Quantitative analysis is not difficult. Find the data, plug it into the appropriate equation, and you have your result.

Common fundamentals include: price/earnings; price/book; dividend yields. Analysts usually arrive at similar numbers.

The difficulty lies in interpreting those results.

Qualitative Analysis

In value investing, the proper qualitative analysis is what separates value from junk. This is critical, because based on the quantitative data, terrible investments often look like value opportunities.

A low price/earnings ratio may suggest value. Or it may indicate a company heading for difficulties. The same is true for companies with high dividend yields. The exact same ratio in two different companies may indicate the complete opposite future potential.

When we cover the common fundamentals later, we will go through examples.

Qualitative analysis assesses an asset’s systematic and nonsystematic risk factors to make sense of the quantitative results. Risks involving: general economic conditions; management; operations; industry; competitors; customers and suppliers; credit and financial; tax and regulatory; legal.

Intrinsic Value

By conducting both quantitative and qualitative analysis, you attempt to determine a stock’s intrinsic value.

But what is this true value?

And that is the problem with value investing.

What exactly is a stock’s intrinsic value?

As I stated above, most analysts will arrive at similar quantitative results. Then they use quantitative analysis to adjust the data to reflect what they believe is the asset’s “correct” value.

Based on your analysis, you will arrive at one number. Other investors, using the same publicly available data, will arrive at different valuations. Some will be higher, some lower.

No matter how good the analysis, many investors will be incorrect.

And no matter how poor the analysis, some investors will get lucky.

Further, unforeseen events may render even the perfect analysis irrelevant.

Consider the September 11, 2001 terrorist attacks in the US.

On September 10, certain assumptions were made in respect of investments. Interest rates, government spending, oil prices, consumer demand, company revenues, to list a few variables.

On September 11, many factors changed completely. Share prices across the board fell. The US government launched a long and costly war. And so on.

In the space of 24 hours, many assumptions that investors relied on materially changed. And those changes impacted valuation calculations.

In November, 2016, it was widely expected that Hillary Clinton would win the US presidency. That win would usher in her world views and policies. When Donald Trump won, that required a significant shift in thinking. Forecasts and estimates based on assumptions made in late October required adjustments. Adjustments that impacted fundamental analysis.

Considering that just before the election, pollsters showed Clinton with a 95% probability of winning, it is hard to fault analysts for assuming she would win. But she lost and all analysis became erroneous to some degree.

Determining the “real” value for a company is difficult, if not impossible. As the world and company specific factors change, so too does its future value. Without a crystal ball, very hard to get it right.

As well, what you consider an asset’s true value will be different than others. Think of buying or selling a house or used car. Pretty much anything. The value you assign to something is likely different than other parties may believe.

Should You Value Invest?

While it may be impossible to accurately predict a company’s intrinsic value, should you ignore value investing?

Not at all.

Studies often show that value investing outperforms growth strategies.

I do not agree with this as a general statement as other data shows mixed results. But there are some who believe value investing is the only way to go.

I do believe that investors following any investment strategy (e.g., growth, balanced, Japanese equities) must follow the tenets of a value strategy. After all, when you get to the heart of value investing, it is simply common sense.

Find companies that are undervalued relative to what you believe is their true worth.

Then buy their shares.

At its basis, it is that simple.

And even if you follow a growth strategy you need to adhere to these principles.

Apple, Amazon, Facebook, and Google may be considered growth stocks. But even so, you want to buy the one(s) with the best potential. Not the ones that may be overpriced.

Implementing a value investing program requires investing skill. It also takes time and luck to do well picking individual value stocks. It is difficult, but not impossible. As the success of Warren Buffet and others can attest to.

Many investment companies offer value funds. I suggest initially using them if you wish to follow a value strategy.

As you develop experience and confidence in your analysis, then consider trading individual stocks.