Scouring for growth

TORCH-LIGHT

Normally, growth stocks have higher price-earnings valuations than value stocks. Higher valuations reflect the willingness of investors to 'pay up' for companies perceived as rapid growers - to pay more for every rupee of earnings.

Nevertheless, the size of the premium can vary a great deal depending on interest rates, inflation expectations, and investor psychology.

When interest rates are relatively low or falling, investors will countenance a higher P/E for a growth stock because its anticipated returns compare favourably with current investment alternatives.

Conversely, a growth stock may command a relatively lower P/E when rates are rising, because its expected future returns are not so outstanding compared with less risky alternatives.

It is interesting to know how psychology influences valuations which at times in the past have been driven to extremes.

In the late 1960s and early 1970s, for instance, when growth stocks were the darlings of the American market, investors bid up the average P/E ratio to 46 times earnings, which was more than double of the S&P 500 (which, itself, was unusually high) in the US.

As inflation and interest rates climbed, these levels proved excessive and the entire market collapsed. If investors turn their attention away from growth stocks, the premium can shrink drastically and even disappear.

During FY 1999-2000, perceptions about the future changed and new stories caught the imagination of the investing public. The year 1999 was no different from 1994, except that the nature of the dreams was different.

After infusing buoyancy in the secondary market, the information technology sector fueled a boom in the then somnambulant primary capital market.

This frenzy was mainly attributable to the rapid growth and profitability of the software sector, coupled with a paradigm shift in the method of valuations of such stocks. Adding fuel to this fire was the phenomenal increase in valuations of IT stocks in overseas markets, especially at the Nasdaq bourse.

It is said that history repeats itself in the stock markets. This does not mean that every stock will move as it did in the last bull run. Fashions change and new ideas, maybe biotechnology, could gain popularity.

And if you catch on to these waves, the going is good - until fashions change again. This could take years or months. Thus, it is particularly important for growth-stock investors not to 'overpay' for current or future growth.

The higher the relative P/E at the time of investment, the greater the potential decline if the company's performance disappoints Dalal Street.

The next factor, though by no means less important, is the management. Irrespective of whether you are growth or value investor, management is always a key attribute in buying a stock.

But with a growth company which aims to maintain higher-than-average growth rates, the nature of the challenge faced by management is of a higher order.

Without any prejudice to the value school, it is fair to presume that the premium placed on management quality by growth investing is altogether in another league.

This is because, growth investing inherently spans a longer timeframe, over which the weaknesses, if any, of the management begin to manifest themselves.

The same applies to interest rates as well. Typically, growth stocks are more sensitive to interest rates. This has more to do with the growth premium than with debt levels.

Given their steady but above-average growth rates, growth companies obviously get more attractive during the period when interest rates are low or are headed lower.

However, when interest rates head higher, the value of the future cash flows gets impacted quite substantially and the appeal of growth companies does suffer as a consequence.

How many investors know about the value of keeping a close watch on interest rate movements and trends? Isn't this the kind of thing which bond fund holders usually look at?

For equity fund holders, the biggest danger from inflation comes in the form of reduced corporate earnings. In particular, growth stocks - for example, pharma and biotech stocks - are valued based on the companys' future earnings, maybe as much as three to five years or more down the road.

The spectre of higher interest rates calls into question the ability of growth companies to meet their revenue and earnings targets, resulting in a fall in their stock price. Higher rates also cause stock prices to fall because they reduce the present value of future earnings streams.

Interest-sensitive stocks also suffer a drop in price when rates rise. These stocks are traditionally banks and utilities. Interest sensitive stocks normally pay out a regular dividend.

When interest rates rise, the present discounted value of this earning stream falls, reducing the value of this share. This is the very same reason why bond prices fall as interest rates rise. The present value of bonds coupons dip when rates rise.

Therefore, investors can expect a drop in their portfolio value when interest rates rise and when inflation fears surface. Growth stocks and dividend paying companies are the most affected.

Valuing growth stocks is a great challenge. The question of how to value growth stocks is one that has no straightforward or simple answers.

Unlike value investing which is quite well-defined and has easy to understand metrics, growth investing is more difficult to quantify. Discounted Cash Flow (DCF) is one important tool that an investor trying to evaluate growth companies can turn to.

The catch here is that DCF involves several assumptions - the rate at which cash flows will grow, the period of the explicit forecast (for which cash flows have been estimated), the interest rate to be used to discount the future cash flows (because money to be received tomorrow has a lower value today) and an estimate of terminal value (the value at which one expects the stock to trade at the end of the explicit forecast period). This is obviously no easy task, because it involves complex calculations and many assumptions.

Growth-stock investing focuses on well-managed companies whose earnings and dividends 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 can provide long-term growth of capital, preserving the investor's purchasing power against erosion from rising prices.

With valuations at the Indian bourses no longer looking as cheap as it did less than half a year ago, investors must sharpen their growth investing and seek long-term winners. After all, the show must go on.

(The author heads Lotus Strategic Consultants, Mumbai, and can be contacted at ceolotus@hotmail.com.
Disclosure: He has no outstanding interest in the companies discussed here.)