Creating new S-curves - developing new engines of growth - ideally before the current cycle of growth reaches maturity.

Every business goes through the S-curve cycle of growth: 

• infancy (low growth), 
• expansion (rapid growth) and 
• maturity (slow growth).

No matter how successful the product is, growth must slow at some point (maturity phase), due to a number of reasons:

• increased competition, 
• market saturation, 
• technology disruption, 
• regulatory changes and 
• changing consumer preferences.

VALUE CREATION OR DESTRUCTION:  MANAGEMENT'S ROLE

Ultimately, whether a company remains VALUE CREATIVE OR DESTRUSTIVE, depends on how well management understand this inevitability, its mindset and how successful it is in creating new S-curves - developing new engines of growth - ideally before the current cycle of growth reaches maturity.

New S-curves could include 

• tapping into new selling channels and geographies for the existing products, or 
• it could be expansion into a related business - for instance, starting a new product line and going upstream or downstream, or 
• diversification into something entirely different and unrelated.

In short, the S-curve is dynamic over the company's life, that is, the company should continuously reinvent, reinvest and create new S-curves to start new growth cycles. 

We see real-life examples of how this is done every day.

Companies starting new S-curves to start new growth cycles:

QL started Family Mart

YTL Power entered a new S-curve selling power to Singapore and enters the AI related sector.

Padini started Brands' Outlets.

Scientex growing its manufacturing business organically and through acquisitions and entering the property development sector business successfully.

KGB supplying its products to many industries and to many countries.

Facebook promoting Metaverse (but unsuccessfully).

Microsoft branching into cloud computing and AI.

Amazon continues to reinvent itself, selling books initially, and now selling almost everything. (Many new S-curves)

Of course, growth comes with a price too. 

Some growths can be good and some can be very bad for the companies.

Shareholder wealth in a company is destroyed with failure to find new S-curve.

With no growth or business in decline, value of company shrinks (contracting PE x lower EPS); value is destroyed.

There are many companies in Bursa Malaysia in this category. 

Many factors can derail any business forecast.

Forecasting future growth is considerably imprecise

Forecasting sales or profits many years into the future is considerably more imprecise, and a great many factors can derail any business forecast. 

There are many investors who make decisions solely on the basis of their own forecasts of future growth. After all, the faster the earnings or cash flow of a business is growing, the greater that business’s present value. 

Difficulties confronting growth-oriented investors

Yet several difficulties confront growth-oriented investors. 

• First, such investors frequently demonstrate higher confidence in their ability to predict the future than is warranted. 
• Second, for fast-growing businesses even small differences in one’s estimate of annual growth rates can have a tremendous impact on valuation.  
• Moreover, with so many investors attempting to buy stock in growth companies, the prices of the consensus choices may reach levels unsupported by fundamentals. 
• Investors may at times be lured into making overly optimistic projections based on temporarily robust results, thereby causing them to overpay for mediocre businesses. 
• When growth is anticipated and therefore already discounted in securities prices, shortfalls will disappoint investors and result in share price declines.

When a good business can become a bad investment

 As Warren Buffett has said, “For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.” 

Growth investors tend to oversimplify growth into a single number

Another difficulty with investing based on growth is that while investors tend to oversimplify growth into a single number, growth is, in fact, comprised of numerous moving parts which vary in their predictability. 

Sources of earnings growth

For any particular business, for example, earnings growth can stem from increased unit sales related 

• to predictable increases in the general population, 
• to increased usage of a product by consumers, 
• to increased market share, 
• to greater penetration of a product into the population, or 
• to price increases. 

Specifically, a brewer might expect to sell more beer as the drinking-age population grows but would aspire to selling more beer per capita as well. Budweiser would hope to increase market share relative to Miller. The brewing industry might wish to convert whiskey drinkers into beer drinkers or reach the abstemious segment of the population with a brand of nonalcoholic beer. Over time companies would seek to increase price to the extent that it would be expected to result in increased profits. 

Some of these sources of earnings growth are more predictable than others. 

• Growth tied to population increases is considerably more certain than growth stemming from changes in consumer behavior, such as the conversion of whiskey drinkers to beer. 
• The reaction of customers to price increases is always uncertain. 

On the whole it is far easier to identify the possible sources of growth for a business than to forecast how much growth will actually materialize and how it will affect profits. 

Venturing Into Early-Stage Growth Stocks

For investors, young growth stocks can trigger dreams of wealth - and nightmares of poverty. These companies are often early-stage ventures that offer rapid revenue growth, but have yet to deliver earnings growth or much of a business track record. As such, the potential returns can be enormous, but investing in these stocks can also be risky. There are several points investors should consider when analyzing early-stage growth stocks.

Overview
The key features of early-stage growth stocks are rapid revenue growth but no earnings. Spending heavily to gain a market foothold, many growth companies - even those with strong sales revenue growth - can lose a lot of money in their early years. At the same time, these companies normally have a limited operating history, making it even more difficult for investors to judge the companies' current performance and value.

To stay on the safest side, many investors prefer to steer clear of companies with these risky characteristics. On the other hand, the next biggest and most rewarding stocks may be found among these kinds of stocks. The trick is to size up the risk.



To demonstrate how to evaluate an early-stage growth company's risk, let's consider Nasdaq-listed XM Satellite Radio Holdings (XMSR), a company that has been striving to become an established player in the fast-growing global satellite radio broadcasting market. Turning to XM's 2004 Form 10-K Annual Report, let's go over some key points for assessing the risk of an emerging growth stock.

Sales Growth
For starters, consider this growth trend. XM Satellite Radio delivered staggering sales growth in 2004. Scroll down to Selected Consolidated Financial Data (p.28, or Item 6 on the Table of Contents), and you will see that revenues grew from $0 in 2000, when XM Satellite Radio became publicly-listed, to more than $244 million in 2004. With sales growth of 168% in 2004, XM appears to have successfully taken advantage of growth opportunities. Importantly, the pace of sales growth was steadily upward - absent of unexpected swings - giving investors some reason to be confident that successful sales growth would continue.

Still, investors should take care: while the company's sales-growth record over the five-year period was certainly impressive, there is no guarantee that the company will be able to maintain that rate of growth into the future. In fact, the pace of growth could very well decline as the company satisfies demand for its products.

Profitability
You need to determine whether revenue growth is profitable. Look further down at XM's Consolidated Statement of Operations (p. F-5). The net loss shows us that in 2004, XM lost a lot of money - more than $642 million. That's no surprise: the company spent heavily on sales and marketing and invested in new radio programming content to attract subscribers. If those investments pay off, earnings could materialize.

But savvy investors want a clearer indication that one day the company will produce earnings. A good place to look is the company's profit margins. There should be signs that profit margins are steadily getting better - even if that means the margins are simply getting less negative.

Net Profit Margins = Net Profits after Taxes / Sales

Investors should be somewhat reassured. Although the company's losses accelerated between 2002 and 2004, its net margins saw a dramatic improvement, moving from a whopping -2,174.3% to -188.6% over the time period. Judging by its margin performance trend, XM offered heartening signs that it is moving towards profitability.

Cash Generation or Cash Burn?
Cash flow is another serious issue for newer, unprofitable companies in rapidly growing industries. As it can take time for early-stage companies to generate cash from operations, their survival depends on effective cash management so that they have an adequate cash supply to meet expenses. Emerging growth companies can face years of living on their bank balances. If a company eats through cash too fast, it runs the risk of going out of business.

So, it is good practice to look at the company's cash flow from operation.You will find that figure on XM's Consolidated Statement of Cash Flows (p. F-6). Investors may be discouraged to learn that XM's payments exceeded its cash receipts by more than $85.6 million in 2004 (see "net cash used in operating activities"). On the other hand, that number is significantly less than the $245 million of cash consumed the year before. That could signal a move towards cash flow breakeven.

When analyzing companies like XM that are cash flow negative, it's also worthwhile checking their burn rate, the rate at which a company currently uses up its supply of cash over time.

You will see on XM's Consolidated Balance Sheet (p. F-4) that at end-2004 the company had more than $717 million in cash in the bank. Assuming that annual net cash used in operating activities of $85.6 million and investing activities of $36.3 million (found lower on the Consolidated Statement of Cash Flows) stay at the same level, then XM has nearly six years before it will run out of cash. In other words, XM has a comfortable cushion of cash that will tie it over until it starts to generate cash internally. Investors need not worry about XM being forced to seek additional funds to finance day-to-day operations.

Fair Value
The best way to curb risk is to invest in companies at a fair value. Because a lot of emerging growth stocks like XM have no earnings, investors have to cast aside the traditional price-to-earnings (P/E) ratio for coming up with a fair valuation. In the absence of a P/E ratio, you can calculate the price-to-sales ratio and compare that figure with other, similar companies.

To find XM' price-to-sales ratio, we look at its stock price on the day it filed its 2004 Form 10-K Annual Report, which was on Mar 4, 2005. On that day, the stock closed at $33.11 (see XM's trading quote that day on Investopedia's stock research resource). With 29.11 million shares outstanding, XM's market value was about $7 billion.

So, at the end of 2004, XM traded for more than 28 times its current sales ($7 billion market value divided by 2004 sales of $244 million). At first glance, that appears to be an awfully rich valuation - normally investors look for companies with price-to-sales ratios in the single digits or even lower. However, priced at 28 times sales, XM is still less expensive than its closest peer Sirius Satellite Radio (SIRI), which traded for more than 80 times sales at year-end 2004. New-media technology stocks are typically very pricey - so some investors might argue that the company's rapid rate of growth combined with its steady progress towards profitability justify the high price-to-sales ratio. Then again, a lot of others would steer clear of the stock at that price.

Another way to evaluate fair value is discounted cash flow analysis. It offers a more rigorous approach to valuing emerging growth stocks. The starting point is forecasting the company's free cash flows available to shareholders. These are earnings adjusted for expenses and income that are not in cash (such as depreciation) and adjusted for required investments and changes in working capital. The series of forecasted free cash flows is then brought to current values by discounting with the company's cost of equity or overall cost of capital.

The Bottom Line
Investing in early-stage growth stocks can be a bit of guessing game. These companies are offering new services and products, and in many cases they are creating new markets. It can be awfully difficult to know their prospects with much certainty. That said, there are ways to identify their risks. Analysis of sales revenues, profitability and cash generation can help distinguish winners from losers.


Read more: http://www.investopedia.com/articles/stocks/05/earlygrowth.asp#ixzz2KA9GZFz4

Is Growth Always A Good Thing?

Rapid growth in revenue and earnings may be top priorities in corporate boardrooms, but these priorities are not always best for shareholders. We are often tempted to invest large amounts in risky or even mature companies that are beating the drum for fast growth, but investors should check that a company's growth ambitions are realistic and sustainable.

Growth's Attraction
Let's face it, it's hard not to be thrilled by the prospect of growth. We invest in growth stocks because we believe that these companies are able to take shareholder money and reinvest it for a return that is higher than what we can get elsewhere.

Besides, in traditional investing wisdom, growth in sales earnings and stock performance are inexorably linked. In his book "One Up on Wall Street," investment guru Peter Lynch preaches that stock prices follow corporate earnings over time. The idea has stuck because many investors look far and wide for the fastest-growing companies that will produce the greatest share-price appreciation.



Is Growth a Sure Thing?
That said, there is room to debate this rule of thumb. In a 2002 study of more than 2,000 public companies, California State University finance professor Cyrus Ramezani analyzed the relationship between growth and shareholder value. His surprising conclusion was that the companies with the fastest revenue growth (average annual sales growth of 167% over a 10-year period) showed, over the period studied, worse share price performance than slower growing firms (average growth of 26%). In other words, the hotshot companies could not maintain their growth rates, and their stocks suffered.

The Risks
Fast growth looks good, but companies can get into trouble when they grow too fast. Are they able to keep pace with their expansion, fill orders, hire and train enough qualified employees? The rush to boost sales can leave growing companies with a deepening difficulty to obtain their cash needs from operations. Risky, fast-growing startups can burn money for years before generating a positive cash flow. The higher the rate of spending money for growth, the greater the company's odds of later being forced to seek more capital. When extra capital is not available, big trouble is brewing for these companies and their investors.

Companies often try increasingly big - and risky - deals to push up growth rates. Consider the serial acquirer WorldCom. In the 1990s, the company racked up growth rates of more than 20% by buying up little-known telecom companies. It later required larger and larger acquisitions to show impressive revenue percentages and earnings growth. In hopes of sustaining growth momentum, WorldCom CEO Bernie Ebbers agreed to pay a whopping $115 billion for Sprint Corp. However, federal regulators blocked the deal on antitrust grounds. WorldCom's prospects for growth collapsed, along with the company's value. The lesson here is that investors need to consider carefully the sustainability of deal-driven growth strategies.

Being Realistic About Growth
Eventually every fast-growth industry becomes a slow-growth industry. Some companies, however, still pursue expansion long after growth opportunities have dried up. When managers ignore the option of offering investors dividends and stubbornly continue to pour earnings into expansions that generate returns lower than those of the market, bad news is on the horizon for investors.

For example, take McDonald's - as it experienced its first-ever losses in 2003, and its share price neared a 10-year low, the company finally began to admit that it was no longer a growth stock. But for several years beforehand, McDonald's had shrugged off shrinking profits and analysts' arguments that the world's biggest fast-food chain had saturated its market. Unwilling to give up on growth, McDonald's accelerated its rate of restaurant openings and advertising spending. Expansion not only eroded profits but ate up a huge chunk of the company's cash flow, which could have gone to investors as large dividends.

CEOs and managers have a duty to put the brakes on growth when it is unsustainable or incapable of creating value. That can be tough since CEOs normally want to build empires rather than maintain them. At the same time, management compensation at many companies is tied to growth in revenue and earnings.

However, CEO pride doesn't explain everything: the investing system favors growth. Market analysts rate a stock according to its ability to expand; accelerating growth receives the highest rating. Furthermore, tax rules privilege growth since capital gains are taxed in a lower tax bracket while dividends face higher income-tax rates.

The Bottom Line
Justifications for fast growth can quickly pile up, even when it isn't the most prudent of priorities. Companies that pursue growth at the cost of sustaining themselves may do more harm than good. When evaluating companies with aggressive growth policies, investors need to determine carefully whether these policies have higher drawbacks than benefits.


Read more: http://www.investopedia.com/articles/fundamental/03/082003.asp#ixzz2KA5lFtVB

Confine your study to companies with good sales or earnings growth.

Don't bother to continue with a stock study if sales or earnings growth is inadequate.

Sales growth is inadequate if it is below the guidelines for the size of the company you are studying (ranging from around 7 percent for a large company to 12 percent for a smaller one).

Earnings growth should be around 15 percent or better; but you can accept slower growth from companies whose dividends contribute substantially to the total return.

Earnings Growth: Good Growth and Bad Growth

GROWTH FIGURES FOR ANHEUSER-BUSCH

Take Anheuser-Busch. Ten-year figures to 2002, using the Value Line summaries, show the following:

Year	Earnings per share	Return on equity %	Return on capital %
1993	.89	23.0	14.9
1994	.97	23.4	15.2
1995	.95	22.2	14.3
1996	1.11	27.9	17
1997	1.18	29.2	15.6
1998	1.27	29.3	16.5
1999	1.47	35.8	17.7
2000	1.69	37.6	18.2
2001	1.89	42.0	18.8
2002	2.20	63.4	21.9

GROWTH IN EPS

For Mary Buffett and David Clark, earnings per share growth, and its ability to keep well ahead of inflation, is a key factor in the investment strategies of Warren Buffett. Earnings that are consistently increased are an indication of a quality company, soundly managed, with little or no reliance on commodity type products. This leads to predictability of future earnings and cash flows.

On the other hand, with a company whose earnings fluctuate, future cash flows are less predictable. The reasons may be poor management, poor quality or an over reliance on products that are susceptible to price reductions.

Take an imaginary company with the following earnings per share:

Year	EPS
1	2.00
2	2.25
3	2.98
4	1.47
5	1.88
6	-.65
7	2.75
8	2.20
9	1.98
10	3.01

The only conclusion that follows from these figures is that this company has good years and bad years. Year 11 might be great, it might be dreadful, or it might be average. The only certainty here is the unpredictability.

Of course, a fall in margins for one or two years may be as a result of once only factors and this can provide buying opportunities.

The difficulty is making the judgment as to 

• whether there is something permanently wrong, or 
• whether the problem has been isolated and resolved.

WARREN BUFFETT AGAIN ON GROWTH

For Warren Buffett the important thing is not that a company grows (he points to the growth in airline business that has not resulted in any real benefits to stockholders) but that returns grow. In 1992, he said this:

‘Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long term market value.
In the case of a low-return business requiring incremental funds, growth hurts the investor.’


http://www.buffettsecrets.com/company-growth.htm

PAST GROWTH AS A PREDICTABILITY FACTOR

Although a consistent record of increases in earnings per share is not of itself an absolute predictor of either further increases, or the rate of any increases,Benjamin Graham believed that it was a factor worthy of consideration.

In addition, it is logical to conclude that a company that has had regular and consistent increases in earnings per share over a protracted period is soundly managed.

WHAT WARREN BUFFETT LOOKS FOR IN COMPANY GROWTH

An investor likes to see a company grow because, if profits grow, so do returns to the investor. The important thing for the investor, however, is that the company increases the returns to shareholders. A company that grows, at the expense of shareholder returns, is not generally a good investment. As Warren Buffett said in 1977:

‘Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5 % increase in earnings per share.’

WARREN BUFFETT AGAIN ON GROWTH

For Warren Buffett the important thing is not that a company grows (he points to the growth in airline business that has not resulted in any real benefits to stockholders) but that returns grow. In 1992, he said this:

‘Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long term market value.

In the case of a low-return business requiring incremental funds, growth hurts the investor.’

What Warren Buffett Looks for in Company Growth

WHAT WARREN BUFFETT LOOKS FOR IN COMPANY GROWTH

An investor likes to see a company grow because, if profits grow, so do returns to the investor. The important thing for the investor, however, is that the company increases the returns to shareholders. A company that grows, at the expense of shareholder returns, is not generally a good investment. As Warren Buffett said in 1977:

‘Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5 % increase in earnings per share.’

COMPOUNDING EFFECT OF GROWTH

Regular growth in earnings per share can have a compound effect if all, or substantially all, of the profits are retained. A company, for example, with earnings per share of 40 cents growing regularly 9 % would, in ten years produce earnings per share of 87 cents.

Of course, if the investor can do better with retained earnings than the company can, his or her interests are better served by a full distribution of profits.

PAST GROWTH AS A PREDICTABILITY FACTOR

Although a consistent record of increases in earnings per share is not of itself an absolute predictor of either further increases, or the rate of any increases,Benjamin Graham believed that it was a factor worthy of consideration.

In addition, it is logical to conclude that a company that has had regular and consistent increases in earnings per share over a protracted period is soundly managed.

WARREN BUFFETT AGAIN ON GROWTH

For Warren Buffett the important thing is not that a company grows (he points to the growth in airline business that has not resulted in any real benefits to stockholders) but that returns grow. In 1992, he said this:

‘Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long term market value.

In the case of a low-return business requiring incremental funds, growth hurts the investor.’

GROWTH FIGURES FOR ANHEUSER-BUSCH

Take Anheuser-Busch. Ten-year figures to 2002, using the Value Line summaries, show the following:

Year	Earnings per share	Return on equity %	Return on capital %
1993	.89	23.0	14.9
1994	.97	23.4	15.2
1995	.95	22.2	14.3
1996	1.11	27.9	17
1997	1.18	29.2	15.6
1998	1.27	29.3	16.5
1999	1.47	35.8	17.7
2000	1.69	37.6	18.2
2001	1.89	42.0	18.8
2002	2.20	63.4	21.9

GROWTH IN EPS

For Mary Buffett and David Clark, earnings per share growth, and its ability to keep well ahead of inflation, is a key factor in the investment strategies of Warren Buffett. Earnings that are consistently increased are an indication of a quality company, soundly managed, with little or no reliance on commodity type products. This leads to predictability of future earnings and cash flows.

On the other hand, with a company whose earnings fluctuate, future cash flows are less predictable. The reasons may be poor management, poor quality or an over reliance on products that are susceptible to price reductions.

Take an imaginary company with the following earnings per share:

Year	EPS
1	2.00
2	2.25
3	2.98
4	1.47
5	1.88
6	-.65
7	2.75
8	2.20
9	1.98
10	3.01

The only conclusion that follows from these figures is that this company has good years and bad years. Year 11 might be great, it might be dreadful, or it might be average. The only certainty here is the unpredictability.

Of course, a fall in margins for one or two years may be as a result of once only factors and this can provide buying opportunities.

The difficulty is making the judgment as to whether there is something permanently wrong, or whether the problem has been isolated and resolved.

http://www.buffettsecrets.com/company-growth.htm

How Value Investor identifies Earnings, Sales and Future Growth

The real goal of the value investor is to identify companies with solid financial base that are growing at a faster rate (in terms of sales and earnings) than both their competitors and the economy in general.

All things being equal, share price is likely to increase in value at about the same rate that sales grow.

For dominant companies in major industries, an investor will want a sales growth rate of 5 to 7 percent.  

Within a portfolio, look for an overall sales growth rate of at least 10% annually.

Earnings need not rise every year. Almost all industries operate in cycles, and any company can suffer a temporary setback.

But investors should be wary

• when a company's earnings and sales are erratic without explanation or 
• when sales and earnings are slowly sinking and the company is not taking corrective action.

A growth maverick shares his ideas.

Chuck Akre on the Search for Compounding Machines

A growth maverick shares his ideas.

Kinnel: You've said you look for "compounding machines." Would you explain what that means?

Akre: When I started in the investment business a good while ago, I was not trained for it in a traditional sense. I had been a pre-med major, and then I was an English major. So, I quite naturally had all kinds of questions about the investment business, and among them were the questions of what makes a good investor and what makes a good investment, and taking a look and studying different asset classes using data from what is now your subsidiary Ibbotson and other places. I came across the well-known piece of information that over the last roughly 90 years common stocks in the United States have had an annualized return that's in the neighborhood of 10%.

So, my question naturally was, well, what's important about 10%? What I concluded was that it had a correlation with what I believe was the real return on the owners' capital of all those businesses across all those years, all kinds of different balance sheets and business models--i.e., that the real return on owners' capital was a number that was probably in the low teens and therefore that kind of 10%-ish return correlated with that, and it caused me to posit that my return in an asset would approximate the ROE of a business given the absence of any distributions and given constant valuation. So, then, we say, well, if our goal is to have returns which are better than average, while assuming what we believe is the below-average level of risk, then the obvious way to get there is to have businesses that have returns on the owners' capital which are above that.

Early in the 1970s, I came across a book written by a Boston investment counselor, whose name was Thomas Phelps. And the book he wrote was called 100 to 1 in the Market. You probably know from the history books that Peter Lynch was around Boston in those days, and he was talking about things like "10-Baggers." But here was Thomas Phelps, who was talking about "100 to 1." He documented characteristics of these businesses that caused one to have an experience, where they could make 100 times their investment. The answer is, of course, it's an issue at the rate at which they compounded the shareholders' capital on a per unit of ownership basis and those that compounded the shareholders' equity at a higher rate had higher returns over long period of years. And so that's what comes into play is this issue of compounding compound machines, and we're often identified with this thing in our process that we call the three-legged stool. The legs of the stool have to do with the business models that are likely to compound the shareholders' capital at above-average rates, combined with leg two, people who run the business who are not only killers at running the business but also see to it that what happens at the company level also happens at the per share level--and then number three, where because of the nature of the business and the skill of the manager there is both history as well as an opportunity to reinvest all the excess capital they generate to reinvest that in places where they earn these above-average rates of return.

The most critical piece of that is the last leg, that reinvestment leg. Can you take all the extra capital you generate and reinvest it in ways that you can get continued earnings above-average rates of return? And that's at the core of what we're after in our investments.

Kinnel: On the sell-side, deterioration on those key fundamentals may lead you to sell, but do you also sell on valuation?

Akre: So, in response to your first observation, deterioration to any one of those three will certainly cause us to re-evaluate it. It won't automatically cause us to sell, but it will certainly cause us to re-evaluate it. Our notion is that if we don't get those three legs right where there develop differently in the future than they have in the past, theoretically our loss is the time value of money that it hasn't always been the case. But the deterioration of one of those legs or more than one of those legs diminishes the value of that compounding and, indeed, is likely to cause us to change our view. That's number one.

Number two, the issue of selling on valuation is way more difficult for us. And what we've said is that from a matter of life experience, if I have a stock that's at $40 and I think it's way too richly valued and I sell it with a goal of buying it back at $25, my life experience is it trades to $25.01 or trades through $25 and back up and it trades 200 shares there.   The next time I look at it, it's $300, and I've missed the opportunity. It's my way of saying that the really good ones are too hard to find.  

If I have one of these great compounders, I'm likely to continue to own it through thick and thin knowing that periodically, it's likely to be undervalued and periodically likely to be overvalued. The things that cause us to sell when one or more of the legs of the stool deteriorates. Occasionally, on a valuation basis, maybe we'll take some money off the table.

Lastly, if we're trying to continue to maintain a very focused portfolio, if we run across things that we think are simply better choices, then we may make changes based on that.


http://news.morningstar.com/articlenet/article.aspx?id=534635

Avoiding "BAD" Growth

Investing in growth companies would be a lot easier if all business growth were created equal, but, unfortunately, it is not.

Investors must be wary of "bad" growth.  By bad growth, we mean growth in a business that is likely to produce an unattractive return on the capital invested to generate that growth.

For instance, although all the major airlines were able to achieve substantial growth of their business, Southwest Airlines was the only carrier that was able to generate a level of retun on invested capital that justified the rapid reinvestment in the business. 

Bad growth often stems from a "growth for growth's sake" mentality that results in costly acquired growth or misguided attempts to diversify the business. 

Investors shold be wary of growth initiatives that depend on the integration of sizable acquired businesses or that stray from a company's core mission.

Speculative-Growth Stocks - What's the Growth Trend?

Rapid sales growth won't do us any good if it can't be sustained.

We want staying power, not sales growth of 50% one year and shrinkage the next.

Even though it has only been around for a few years, Yahoo has been one of the most consistent Internet stocks around, growing steadily without a lot of wild swings from quarter to quarter.  

• The pace of that growth has been steadily declining (from 230% in 1997 to 120% in the first quarter of 2000), but that's to be expected as a company gets bigger and grows from a larger base.  
• Yahoo has demonstrated a lot of staying power, at least by the standards of Internet stocks.

So which Stock Type do you wish to add to your portfolio?

To highlight fundamental differences between companies, examine each company's historical record, growth rates, cash flows and other financial data.

Based on these fundamental differences, assign it to one of eight groups.  These stock types are:

1. Speculative Growth
2. Aggressive Growth
3. Classic Growth
4. Slow Growth
5. High Yield
6. Cyclicals
7. Hard Assets
8. Distressed.

These stock types address the question:   What kind of company is this?









Here is a quick overview of these very different companies.


Speculative Growth:  Yahoo YHOO.  The premier Internet portal has become one of the giants of the online world in 1999, with an audience in the tens of millions.  It has become consistently profitable, unlike most of its online brethren, but its track record is still so short that it is definitely risky.


Aggressive Growth:  Starbucks SBUX.   The coffee chain has grown like gangbusters while also showing a healthy profit, the two most important characteristics of an aggressive growth stock.


Classic Growth:  McDonalds MCD.  the fast-food giant is a stereotypical classic growth stock:  A well-known name with an established track record.  It's growing steadily, but not as fast as speculative growth or aggressive growth companies. 


Slow Growth:  Procter & Gamble PG.  The consumer-products giant is a good example of this type; its growth is slower than that of even classic-growth companies, but it makes up for this lack of growth with high profitability.


High Yield:  Philip Morris MO.  The food and tobacco giant's stock was hammered in 1999, but the company still gives back much of its enormous cash flow to shareholders in the form of a hefty dividend.  


Cyclicals:  United Technologies UTX.  This industrial conglomerate is a great example of a cyclical stock.  Its business - aerospace equipment, air conditioners, and elevators - are highly sensitive to the performance of the general economy.


Hard Assets:  Barrick Gold ABX.  This company is one of the most consistently profitable gold-mining stocks, but it also illustrates many of the charcteristics unique to companies that sell hard assets such as minerals or oil.


Distressed:  Silicon Graphics SGI.  This maker of computer workstations and server systems was once a hot technology stock, but it has suffered through a lot of problems since the mid-1990s and has seen its stock price tank.

ROE and Internet Stocks

As an example, consider the fastest growing segment of 1999, Internet stocks.

Most Internet companies are growing rapidly, but few of them are generating profits.



Apart from America Online AOL and its 25% ROE in 1999, none have generated a high return on capital. 


In 1999, the ROE for market darling Amazon.com AMZN was negative 270%.

• In other words, for each dollar shareholders had invested in the company, Amazon lost $2.70.  
• To replenish the lost capital, the company must either issue debt or turn to shareholders for more money -  and there are still plenty of people willing to pony up the money to own a piece of Amazon.  
• If Amazon is going to justify its price, it will eventually have to generate good returns on capital, and whether it can do that depends on which pundits you listen to.  

But there is no argument that returns on capital are the engine that drives stock prices in the long run.


Companies that go on to earn good returns on capital - ROEs of more than 15% or 20% - will probably make good investments.   

Those that struggle to earn a decent return will probably be wretched investments, regardless of how fast they grow.  

So, if someone tries to talk you into investing $10,000 in a restaurant or a few hundred share of an Internet stock, don't ask how fast the company will grow.  Ask how the heck it is going to earn a good return on its capital.

The objective of fundamental analysis is to determine a company's intrinsic value or its growth prospects.

Fundamental analysis

Fundamental analysis is the study of the various factors that affect a company's earnings and dividends.  Fundamental analysis studies the relationship between a company's share price and the various elements of its financial position and performance.

Fundamental analysis also involves a detailed examination of the company's competitors, the industry or sector it is a member of and the broader economy.

Fundamental analysis is forward looking even though the data used is by and large historical.  The objective of fundamental analysis is to determine a company's intrinsic value or its growth prospects.  This intrinsic value can be compared to the current value of the company as measured by the share price.  If the shares are trading at less than the intrinsic value then the shares may be seen as good value.

Many people use fundamental analysis to select a company to invest in, and technical analysis to help make their buy and sell decisions.

Factors affecting future earnings prospects of a company:

1. Change in senior management
2. New efficiency measures
3. Product innovations
4. Acquisition of another business
5. Industrial action

Analysing individual companies

The analysis of an individual company has two components:

-  The 'story' - what the company does, what its outlook is
-  The 'numbers' - the financials of the company, balance sheet and income statement and ratio analysis.

Unfortunately, balance sheet and ratio analysis is probably the most daunting part of fundamental analysis for non-professional investors.  A large number of numerical techniques appear to be used.  However, you can make it less painful by adopting a methodical approach and by always remembering that behind all the numbers is a real business run by real people producing real goods and services, this is the part we call "the story".

It is unlikely that you will need to do the number crunching for every company, your time will be more profitably spent developing the company story.  Balance sheets and ratio analysis, both historical and forecast, can be obtained from either a full service or discount stockbroker.


What are you trying to learn about a company?

Before trying to leap into the calculations behind fundamental analysis there are some basic questions that are worth considering as a starting point:

1. Where is the growth in the company coming from?
2. Is the growth being achieved organically or through acquisition?
3. Is turnover keeping pace with the sector and with competitors?
4. What about the profit margin - is it growing?  Is it too high compared to competitors?  If it is too high then new competitors could enter on price reducing margins.  Low earnings could suggest control of the cost base has been lost or factors outside the company's control are squeezing margins.
5. To what extent do profits reflect one-off events?
6. Will profits be sustainable over the long term?

Companies are multidimensional.  For example, debt funding may have increased - this may be a positive move if the funds produce new productive assets.



Fundamental analysis (Summary)

When you buy shares you are becoming a part owner in that business.

To make an informed decision if you want to be an owner in that business, it is important to understand how that company operates and what its prospects are.

To understand a company, you can read its annual report which is one of the most important publications it releases to the market.

Analysing an annual report gives you the ability to build a good picture of how that business has performed over the past 12 months and what its prospects might be for the future.

To compare the annual reports and prospects of different companies, there are commonly used financial ratios, these include dividend per share, dividend yield, PE ratio and earnings per share.



http://www.asx.com.au/courses/shares/course_10/index.html?shares_course_10

Growth, overtrading and overcapitalization. Controlled and managed growth is critical to the future of a business.

Many businesses strive for growth.  There is a belief that fast growth is the best way to build a successful business.  However, is rapid growth the best option for business with relatively low cash and limited access to new external finance?



Overtrading

'Overtrading' is an imbalance between the work a business receives and its capacity to do it.  Overtrading is a symptom of fast-growing businesses, which chase sales and profitability at the expense of liquidity.

This is common in new businesses, which tend to offer long credit periods to customers in order to establish themselves in a new market.  At the same time many suppliers offer only short credit periods (or insist on cash payments) as the new business has no track record.  This gap between paying suppliers and receiving cash from customers is often financed via overdrafts.  Eventually overtraded businesses enter a negative cycle where banks will not extend their overdraft any further.  Growing interest costs and the associated debt means their financial status eventually reaches insolvency.  

"Yesterday is a cancelled check.  Today is cash on the line.  Tomorrow is a promissory note."



Overcapitalization

On the opposite end of the spectrum of overtrading is overcapitalization.  An overcapitalized business has excess assets, which are not being utilized effectively.  In essence it is not maximising returns in relation to the size of its assets and in particular its cash.  This is not so risky as overtrading but the money should be 

• used to finance long-term projects or 
• returned to shareholders.

Overcapitazation is often a symptom of a previously successful, mature businesses with minimal future growth prospects.



Finding the balance

It is difficult for a growing business to turn away sales, but success can kill a business as quickly as failure.

Controlled and managed growth is critical to the future of a business.

• Growth demands investment and only a certain level of growth can be financed by internally generated cash.  
• Further growth requires external investment and there's only so much money shareholders will commit and banks will lend in the short term.  

Every person who owns shares in a company wants it to grow

Every person who owns shares in a company wants it to grow

When investors talk about "growth", they're not talking about size.  They're talking about profitability, that is, earnings.

It means the profits are growing.  The company will earn more money this year than last year, just as it earned more money last year than the year before that.

• A company doubling its earnings in 12 months can cause a wild celebration on Wall Street, because it's very rare for a business to grow that fast.
• Big, established companies are happy to see their earnings increase by 10 to 15% a year, and
• younger, more energetic companies may be able to increase theirs by 25 to 30%. 

One way or the other, the name of the game is earnings.  That's what the shareholders are looking for, and that's what makes the stocks go up.

People who buy shares are counting on the companies to increase their earnings, and they expect that a portion of these earnings will get back to them in the form of higher stock prices.

This simple point - that the price of s stock is directly related to a company's earning power - is often overlooked, even by sophisticated investors. 

The earnings continue to rise, the stock price is destined to go up.  Maybe it won't go up right away, but eventually it will rise.

And if the earnings go down, it's pretty safe bet the price of the stock will go down.  Lower earnings make a company less valuable.

This is the starting point for the successful stockpicker.  Find companies that can grow their earnings over many years to come. 

It is not an accident that stocks in general rise in price on average of about 8% a year over the long term.  That occurs because companies in general increase their earnings at 8% a year, on average, plus they pay 3% as a dividend.

Based on these assumptions, the odds are in your favour when you invest in a representative sample of companies.  Some will do better than others, but in general, they'll increase earnings by 8% and pay you a dividend of 3%, and you'll arrive at your 11% annual gain.


Stock Price Watchers

The ticker-tape watchers begin to think stock prices have a life of their own.

• They track the ups and downs, the way a bird watcher might track a fluttering duck.
• They study the trading patterns, making charts of every zig and zag.
• They try to fathom what the "market" is doing, when they ought to be following the earnings of the companies whose stocks they own.

"Expensive Shares"

By itself, the price of a stock doesn't tell you a thing about whether you're getting a good deal.


You'll hear people say: "I am avoiding IBM, because at $100 a share it's too expensive." 

• It maybe that they don't have $100 to spend on a share of IBM, but the fact, that a share costs $100 has nothing to do with whether IBM is expensive. 
• A $150,000 Lamborghini is out of most people's price range, but for a Lamborghini, it still might not be expensive. 

Likewise, a $100 share of IBM may be a bargain, or it may not be.  It depends on IBM earnings.

• If IBM is earning $10 a share this year, then you're paying 10 times earnings when you buy a share for $100.  That's a P/E ratio of 10, which in today's market is cheap. 
• On the other hand, if IBM only earns $1 a share, then you're paying 100 times earnings when you buy that $100 share.  That's a P/E ratio of 100, which is way too much to pay for IBM.