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Growth Investing

Growth investing is investing in the common stock of a company that is growing its sales and earnings consistently above the economy’s growth rate, even in a recessionary environment.

Accelerating or constant growth, however, is often elusive. Historically, a company growing 15% or better is considered to be a solid growth company. Valuation and timing are critical when buying growth.

 Understand the terminology. A growth stock that is said to be “too expensive” merely means its valuation is too high; usually, its P/E ratio is higher than one is willing to pay. Comparing a company’s price earnings ratio with its growth rate is one of the tools used to value a stock.

A reasonable price for a growth stock is a PEG of 1; a P/E ratio equal to a company’s growth rate. The current thinking is that buying a stock with a PEG of 2 times is fair, although many investors pay much more. The author, however, feels that paying 2 times growth (or more) is too expensive. The information age has made it extremely difficult to find a growth stock at a reasonable price and harder to make money on one. The market seems to identify good growth companies very quickly and price in future growth nearly instantaneously, resulting in unrealistically high price earnings multiples. It’s difficult to find an affordable growth stock. Nevertheless, if participating in growth stocks, the goal is to pay a reasonable price.

In some cases, what many investors call growth stocks, are really “story stocks,” that is, companies with a lot of promise, but with no earnings, and some with no sales. Research and Development companies are initially start-up companies. They may transition into growth companies when they start producing sales and profits. When buying a growth stock, you need to monitor the company’s rate of growth and profit margins very closely. The company’s growth rate should be constant or increasing.

If the company is growing nicely, but its growth rate is slowing down, you can find yourself owning a great company but a poor investment. In most cases, you as an investor won’t know that your company’s growth rate is slowing until its books are closed, and by that time the market has usually already adjusted for the change. For example, let say a company is growing 30% a year and after you buy the stock, over the next 4 years its growth rate reduces to 15%, which is still a very nice rate. If the stock is always trading with its P/E ratio equal to its growth rate, here is what happens:

Growth Stock Example 

 

Year


EPS

Growth %
P/E Ratio


Price

1

1.00

30.00

30.00

2

1.26

26.25

33.14

3

1.54

22.50

34.73

4

1.83

18.75

34.29

5

2.10

15.00

31.57

You can see from the above example that it’s hard to make money with growth stocks in today’s economy. Paying a multiple of growth can be a very costly mistake if growth slows and P/E ratios narrow. You need to find companies whose growth rates are constant or increasing, and those are hard to find, and even harder for companies to sustain. The above illustration is a typical example of why growth stocks are having a hard time earning good returns. A true growth company has a consistent or improving growth rate.

Many investors are making blanket assumptions that all drug, consumer product, or technology companies are growth companies, just because they have high P/E ratios or were growth companies in the past. If you really look at the earning trends of these groups in Value Line, many are not consistent earning growers, but are priced as such

The objective is to buy a growth company before the market discovers it. A way to participate in growth stocks, at a reasonable price, is to invest in small cap growth stocks. Many of the smaller growing companies in the United States sell at a discount to their larger peers, but they also carry a great deal of risk. Finding the next Microsoft or Xerox, however, is often more luck than skill. There are hundreds if not thousands of promising growth companies that fizzle out and are never heard from again. 

Young adults should avoid overpaying for growth. Growth stocks are often priced to perfection; a small blip and the stock price can, and often does, crash instantaneously. Be careful when playing the growth game.

 

 

 

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