Friday, 12 February 2010

Growth Stocks and the Defensive Investor

The term 'growth stock' is applied to one which has increased its per-share earnings in the past at well above the rate for common stocks generally and is expected to continue to do so in the future.

Some authorities would say that a true growth stock should be expected at least to double its per-share earnings in 10 years, that is, to increase them at a compound annual rate of over 7.1%.

Obviously stocks of this kind are attractive to buy and to own, provided the price paid is not excessive.

The problem lies there, of course, since growth stocks have long sold at high prices in relation to current earnings and at much higher multiples of their average profits over a past period. This has introduced a speculative element of considerable weight in the growth stock picture and has made successful operations in this field a far from simple matter.

In the past, the "best of common stocks" actually lost 50% of its market price in a 6 months' market decline.

Other growth stocks have been even more vulnerable to adverse development; in some cases not only has the price fallen back but the earnings as well, thus causing a double discomfiture for those who owned them.

For example, a particular stock price advanced 5 times (from $5 to $256 i.e 50x) as fast as the profits (from 40 cents to $3.91 per share i.e. 10x); this is characteristic of popular common stocks. Two years later, the earnings had dropped off by nearly 50% and the price by 80%.

For growth stocks, wonders can be accomplished with
  • the right individual selections, 
  • bought at the right levels, and
  • later sold after a huge rise and 
  • before the probable decline.

But the average investor can no more expect to accomplish this. In contrast, Benjamin Graham think that  the group of large companies that are 
  • relatively unpopular and 
  • therefore obtainable at reasonable earnings multipliers, 
  • offers a sound if unspectacular area of choice by the general public.

Intelligent Investor
by Benjamin Graham

1 comment:

Rob Bennett said...

My view is that investing in a stock because you expect to see huge growth is a risky move. I would never put a large portion of my assets down on such a bet.

But I also believe that the payoff from this kind of bet can be huge in those cases where you get it right. So I think it makes sense to put a small portion of one's portfolio on growth bets.

I have an example from personal experience. A number of years back, the price of Apple Computer crashed. Their share of the computer market had dropped so low that there were people predicting they would go out of business. I had been following an Apple discussion board and noted that believers in Apple are fanatical. There are circumstances in which that can produce a big payoff for a consumer product.

So I felt that the risk in investing in Apple was sky high (it really was possible that the company would go out of business) but that the potential was also sky high (a new consumer product might be such a hit as to bring the company to new heights).

It would be foolish to invest a large portion of one's portfolio on such a company. But a small bet made sense, in my view. The odds were not too bad for those buying after the price had already crashed.