Betting on growth

GUEST COLUMN

A couple of months ago we had discussed 'value investing' in this column. Since there are few worthwhile value stocks left for cherry-picking, the time is now ripe to shift focus to 'growth investing'.

The growth investing style pre-supposes a search for the best companies available in the market. The general modus operandi of such an approach is that investors first try to identify the best growth sector or industry in a given economy.

Investors look for the broad indicators affecting the sector and come to a conclusion about its future prospects. The more difficult part comes in identifying the best performing companies in that sector.

Mind you, the best performing firms need not necessarily mean the ones with the largest sales and profits but the ones that are best placed to exploit the future in relation to the various sector indicators.

Growth-stock investing focuses on well-managed companies whose earnings are expected to grow faster than both inflation and the overall economy.

The real test for a growth company is its ability to sustain earnings momentum even during economic slowdowns. Such companies will provide long-term growth of capital, preserving investors' purchasing power against erosion from rising prices.

Therefore, the basic assumption underlying growth-stock investing is that these companies have above average rates of earnings growth and that, over time, their stock prices will reflect this growth.

The difference between growth and value investing is best understood by the following question. Would you rather buy a great company at a good price or a good company at a great price? Growth investing places great store in buying great companies at good prices, not necessarily at great prices.

The key issues that a growth company faces are: Can it sustain its rapid pace of growth? Can growth be financed internally or does it require to borrow money? Is the company growing faster than its peer group?

This is particularly important because in a favourable business environment, a lot of companies will record high growth rates.

The key is to identify whether the growth is an industry-wide phenomenon or the said company has a key advantage that is propelling it at a higher growth rate than its peer group. And, more importantly, whether that advantage is sustainable.

So, how does one arrive at a growth stock? Investors following a growth style pursue stocks of companies that are experiencing rapid growth in earnings, sales or return on equity.

These stocks tend to have higher P/Es than the overall market. The matrices of growth investing are very different from that of value investing.

Growth investors do not place great emphasis on tools such as P/E, P/B, dividend yield and replacement value. They tend to look more into the future. They are more concerned with prospective P/Es.

In other words, they are more concerned with a company's P/E based on 2005 earnings than 2003 earnings.

Since growth investors place great store on intangibles such as brand value and technological edge, they typically disregard measures such as replacement value and book value.

The line of thought here is that measures such as replacement value and book value are based on accounting entries in the balance-sheet and do not, therefore, capture the intangible assets of the company.

Intangibles could be the company's brands, human capital or intellectual property rights (IPRs). Also, since growth investors are typically on the look-out for high growth businesses, they disregard dividend yields.

The potential for above-average, long-term price appreciation is the principal reason to invest in growth stocks. Over time, growth stock prices that have generally reflected their superior earnings increase.

Growth stocks have often performed best relative to the overall market when the economy is slowing or downright sluggish. At such times, consistent earning growth shines more brightly.

Growth stocks tend to grow significantly when their earnings outperform, which is usually at the beginning and end of most business cycles.

Thus, growth stock prices can be propelled higher by rising earnings or expanding P/E ratios, or both. Of course, this escalator effect can also work in reverse in broad market declines or when a particular company loses its earning momentum.

All stocks are vulnerable to changes in investor psychology, but none more so than growth stocks. Firstly, many of these companies lack the dividend yield that can cushion stock prices in market downdrafts.

Secondly, and more importantly, these companies are expected to increase their earnings at a certain rate. When these expectations are not met, investors can punish the stocks inordinately - even if earnings showed an absolute increase.

By the same token, earnings that exceed projections can trigger sharp price gains.

Growth investing is one of the most difficult approaches to execute practically. The companies that often come under the purview of growth investors have some of the best stories. How many times have we heard of the story of this great sector with the best possibilities?

Very often the price being paid for the 'best' company does not justify its prospects in what is generally referred to as 'trees don't grow up to the sky'.

Since growth stocks are perceived as high quality they are generally quoted at a premium in the market. Often, they also have some of the best ratios (P/E, ROCE, and EVA) in the market.

Nevertheless, growth investors generally pay a price for the future revenues and earnings of the company and don't get bogged down by the present assets of the company. Growth stocks' premium valuations make the shares vulnerable to sharp declines, particularly if earnings are disappointing.

Fast-growing companies need capital to finance their expansion. Most re-invest a high portion or all of their earnings in their own businesses and, therefore, do not pay out any dividends. The price an investor pays for superior performance and returns comes in the form of higher risk.

In India, as also most markets worldwide, much of the good stock price performance is driven by favourable market sentiment. It is also no secret that market sentiment is fickle. A slight sign that a boom is petering out, and investor sentiment does an about-turn.

When the sentiment turns completely sour, as it happened with finance companies through 1995-97 and IT and media companies through 2000-01, valuations can plummet.

Growth stocks carry a high risk, and fluctuations in the stock price, as mentioned above, will probably be more volatile than the market as a whole.

Nevertheless, if one has the stomach for such risks, the patience for the achievement of objectives, and the readiness to make something of the market's fancies, the appeal of growth investing will be hard to match.

(We shall conclude this discussion on growth investing in the next column. The author heads Lotus Strategic Consultants, Mumbai, and can be contacted at ceolotus@hotmail.com.)