The History and Rebirth of Growth Stocks Investing.

By BetterInvesting On April 5, 2012 ·

The editorial of the January issue of BetterInvesting Magazine features a letter from Ted Brooks of North Carolina, who provides a brief history of growth stock investing and the important role BetterInvesting co-founder George Nicholson played in popularizing this investing philosophy. In 1940, when Nicholson was just beginning his “bold experiment” of helping individual investors form investment clubs to pool resources and analyze stocks, growth stock investing was no longer in vogue, replaced by Benjamin Graham’s value approach in light of the 1929 crash.

January 2012 vol 61, No. 5 BetterInvesting Magazine

Reader’s Letter Provides Context for the SSG (The Stock Selection Guide)
In investing circles we tend to take some ideas for granted. In August 2005 we published an article discussing the history of growth stock investing. But a recent letter from reader Ted Brooks of North Carolina, spurred by our article on Better¬Investing’s 60th anniversary in the November issue, provides an excellent history lesson. Below is his letter, edited for Associated Press style and length.

When the Dow Jones industrial average was introduced on May 26, 1896, the world of common stocks was beginning to evolve into three distinct categories: railroads, public utilities and “industrials” (everything else). It is important to note that the “industrial” common stocks were not considered an appropriate investment vehicle for the prudent investor at that time; such investors would limit their holdings to bonds, preferred stock and perhaps an occasional railroad or public utility common stock. This attitude prevailed until around World War I.

While eschewing common stock for bonds and preferred stock sounds strange to our ears, it was not without justification. The DJIA started off as an arithmetic average of the stocks’ closing prices. In other words, the average price of stocks in the DJIA initially bounced between about $40 and $80 and did not break $100 until 1906. What few people realize is that prior to 1915, common stock prices were quoted as a percentage of par value (like bonds and preferreds), and par value was typically $100. If these sound like “junk bond” prices to you — you’re right!

During this period, value investing — focusing on dividend yields, low P/E and discount to book value — prevailed. These concepts carried over readily from the realm of bond and preferred stock analysis.

The man generally credited with introducing the concept of growth stock investing is Edgar Lawrence Smith. Smith’s book, Common Stocks as Long Term Investments, stated that common stocks had a history of outperforming bonds under all economic conditions, going back at least to the end of the Civil War. Now, in early 1925, both the book’s title and theme were outrageous statements that flew in the face of all prevailing logic — something present-day investors do not fully appreciate. Unfortunately, Smith’s book and ideas would see a meteoric rise and fall. …In the first edition of Security Analysis (c. 1934), Benjamin Graham wrote a harsh criticism of Smith and his “growth stock” ¬disciples, and he urged investors to go back to the old rules of valuation that were discarded as obsolete during the bubble (leading to the 1929 crash).…

Against this backdrop, it is easier to understand George Nicholson’s courage in proposing the idea of investment clubs in 1940. Individual investors analyzing stocks? Buying growth stocks? George, where have you been for the last decade — living under a rock?

The BetterInvesting principles of demanding consistent growth in sales and earnings over a period of five-10 years, stable or increasing profit margins and closely watching valuations did not come out of thin air. They all came out of the hard lessons learned in the late 1920s when they were disregarded (as they were during the tech and dot-com bubble of the late 1990s). Nicholson recognized that focusing on these aspects — together with a graphical representation known as the SSG — allowed new investors to gain experience without wading into the trickier aspects of differentiating between a “value play” and a “value trap.” Nicholson’s “bold experiment” required a leader possessing both courage and clear thinking to make it reality in that historical context. I think all of these things combine to make Nicholson’s legacy what it is.

http://blog.betterinvesting.org/investing/the-rebirth-of-growth-stocks/