Sunday, 17 June 2012

What Is a Quality Growth Company? Just What Do We Mean by Growth?

What Is a Quality Growth Company?
To invest only in high quality growth companies, you will have to prospect for good candidates and then analyze and evaluate each.

Invest Only in Good Quality Growth Companies
Depending upon the size or maturity of the company, you should look for companies whose "monotonous excellence" produces consistent annual earnings growth of anywhere from 7% to as much as 20% compounded annually. As these companies grow, their share prices will ultimately follow, and your portfolio will reap the returns.

"Total Return" (the combination of both capital appreciation and divi-dend yield) is, certainly, the name of the game, but it‘s best to invest in companies whose growth, rather than dividend income, is going to provide the bulk of the return.

But it‘s not enough to simply invest in growing businesses. You should also set high standards of quality for the companies in which you invest. Companies of quality will outperform their peers, perform better in economic downturns, and/or see their share prices take large tumbles during the occasional stumble.

Just What Do We Mean by Growth?
As can be seen in the diagram above, a successful company will pass through several phases of growth:
  • The startup phase when earnings are predictably below the break-even point. 
  • A period of explosive growth when the percentage increase in sales and earnings can be spectacular.
  • The mature growth period when revenue becomes so large that it is difficult to maintain a consistent increase in the percentage of growth.
  • The period of stabilization, or decline for companies that do not continue to rejuvenate their product mix or expand their target markets.
You should invest only in companies that have a track record as a public company for at least five years and for which the data is readily available. We are therefore interested in investing in companies that are at least five years into their explosive growth periods but that have not gone past their primes. Obviously, the longer the company has had a successful track record—provided its management copes successfully with maturity—the more stable and risk-free it is apt to be.

Depending upon the size of the company, fundamental investors should expect growth rates that vary from a low of about 7% to a high of around 20%. 
  • Hence, if the company is an established one with sales over the $5 billion mark, a growth rate of as little as 7% might be acceptable. (The Total Return of such a company should have a substantial dividend yield component.)
  • At the other end of the spectrum, the newer company in its explosive growth period should show double digit growth. While we know that growth rates above 20% cannot be sustained forever, we look for higher growth rates as compensation for the increased associated risk.
The chart below provides a rough guideline for the kinds of growth rates that concept suggests. Anything in the light area is acceptable for companies whose revenues (sales) match the scale on the left side.

For example,
  • if a company‘s sales for the current year are in the neighborhood of $300 million, we would look for a growth rate of better than 12%. 
  • For a company with $1 billion in sales, we would want at least 8%. 
These are the standards of growth that we will seek for investment. Higher risk situations involving companies early in their life cycles are speculative and not of investment quality.

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