The importance of growth

If you are going to buy and own expensive shares, you must be very confident that high rates of growth can continue for a long time into the future.   Since no one can predict the future accurately, you need to protect yourself by not paying too high a price for shares.

Knowing how to value shares and understanding the crucial relationship between cash profits and interest rates are important.  Know how much of a company's current share price is based on its current profits and how much is related to future profits growth.  

Though profits growth is important in valuing shares, you should also know how to not pay too much for it.

High share prices can unravel very quickly when profits stop growing.  

Companies which investors like tend to command very high valuations because they are growing turnover and profits rapidly, or are expected to do so   Their shares will have very high multiples of profits and cash flows and very low yield attached to them.  

This can persist for a long time but the dangers for investors of owning expensive or highly-rated shares can be significant when profits stop growing.  

Investors in these shares may often lose a large amount of their investment and learned a brutal lesson of the high risks of owning expensive or highly-rated shares.  This experience has been repeated countless times in the past and will surely happen many times again int he future.

• Using owner earnings to value shares: Setting a ma...
• Using owner earnings to value shares: Earnings Pow...
• Using owner earnings to value shares: Cash yield ...

Growth Stocks

How to select growth stocks?

Selecting growth stocks can be a challenging task, but there are a few key factors to consider when evaluating potential investments. Here are a few strategies that may help you identify growth stocks:

Look for companies with strong revenue and earnings growth: Companies that have consistently grown their revenues and earnings over time are more likely to continue growing in the future. Look for companies with strong revenue and earnings growth rates, and compare them to industry averages.

Look for companies with a competitive advantage: Companies that have a sustainable competitive advantage, such as a strong brand, proprietary technology, or a large market share, are more likely to continue growing in the future.

Look for companies with a solid management team: A strong management team is essential for a company's long-term growth. Look for companies with a track record of success and a clear vision for the future.

Look for companies in growing industries: Companies that operate in growing industries, such as technology, healthcare, or renewable energy, are more likely to benefit from long-term growth trends in those industries.

Look at valuation metrics: Growth stocks tend to trade at higher valuations than value stocks, so it's important to consider a company's price-to-earnings (P/E) ratio, price-to-sales (P/S) ratio, and other valuation metrics to ensure that you are getting a good deal.

Do your own research: It's important to conduct thorough research on the companies you are considering investing in. Look at their financial statements, management team, and industry trends to identify companies with strong fundamentals and growth potential.

It's worth noting that past performance is not a guarantee of future results and that investing in the stock market carries risk. It's always good to do your own research, invest in a diverse set of assets, and have a well-defined investment strategy that aligns with your financial goals.

What are the risks of investing in growth stocks?

Investing in growth stocks can be a great way to achieve strong returns, but it also comes with certain risks. Here are a few of the risks to consider when investing in growth stocks:

High Valuation Risk: Growth stocks tend to trade at higher valuations than value stocks, so there's a risk that the stock's price may not be justified by the company's fundamentals. High valuation can lead to a stock to be overpriced and may result in disappointment in future returns.

Earnings Risk: Growth stocks often have high expectations for earnings growth, which means that if a company misses its earnings estimates, its stock price may drop. This can be especially true for companies that have high P/E ratios.

Industry Risk: Companies that operate in a specific industry are subject to the risks of that industry. For example, companies in the technology sector are subject to rapid technological change, while companies in the healthcare sector may be subject to changes in government regulations.

Interest rate Risk: Growth stocks are sensitive to changes in interest rates, as they are more reliant on future earnings than current dividends. When interest rates rise, the value of future earnings may decrease, causing the stock price to fall.

Concentration Risk: Investing in a small number of growth stocks can lead to concentration risk, which means that if one of the stocks in your portfolio performs poorly, it can have a significant impact on your overall returns.

Political and Economic Risk: Political and economic events such as war, natural disasters, and changes in government policies can also impact a growth stock's performance.

It's important to keep in mind that investing in growth stocks carries a higher level of risk than investing in value stocks. It's important to diversify your portfolio, do your own research and have a well-defined investment strategy that aligns with your financial goals and risk tolerance.

Growth Stocks: Searching for the Sprinters

Growth Stocks: Searching for the Sprinters

by Douglas Gerlach

Investors who focus on growth try to predict which companies will grow faster in the future -- faster than the rest of the stocks in the market, or faster than other stocks in the same industry. If you're successful in buying a company that does grow faster than other companies, then it's likely that the price of that company's stock will increase as well, and you can make a profit.
(My comment: Provided you did not pay too high a price to buy it.)

The stock of a company that grows its earnings and revenues faster than average is known as a growth stock. These companies usually pay few or no dividends, since they prefer to reinvest their profits in their business.

Peter Lynch primarily used a growth stock approach in managing the Magellan mutual fund. Individuals who invest in growth stocks often prefer it because their portfolio will be made up of established, well-managed companies that can be held onto for many years. Companies like Coca-Cola, IBM, and Microsoft have demonstrated great growth over the years, and are the cornerstones of many portfolios. Most investment clubs stick to growth stocks as well.

GROWTH STOCK APPROACH

Every investor would like to select a list of securities that will do better than the average over period of years.

A growth stock may be defined as one which has done this in the past and is expected to do so in the future.

[A company with an ordinary record cannot be called a growth company or a "growth stock" merely because its proponent expects it to do better than the average in the future.  It is just a "promising company."]

It seems only logical that the intelligent investor should concentrate upon the selection of growth stocks.

It is mere statistical chore to identify companies that have "outperformed the averages" in the past.

However, investing successfully in them is more complicated.



Two Catches of Growth Stock Investing

Two catches to watch out for in growth investing.

1.  The common stocks with good records and apparently good prospects sell at correspondingly high prices. 

• The investor may be right in his judgement of their prospects and still not fare particularly well, merely because he has paid in full (and perhaps overpaid) for the expected prosperity.

2.  His judgement as to the future may prove wrong. 

• Unusually rapid growth cannot keep up forever; when a company has already registered a brilliant expansion, its very increase in size makes a repetition of its achievement very difficult.  
• At some point the growth curve flattens out, and in many cases it turns downward.

Naturally, the purchase at a time when popular growth stocks were most favoured and active in the market would have had disastrous consequences.

• They were too obvious a choice.  
• Their future was already being paid for in the price.  
• Popular growth stocks may have failed to continue their progress and have even reported downright disappointing results.

How can your investment into growth stocks be protected?

Presumably, it is the function of intelligent investment to overcome these hazards by the exercise of sound judgement and skillful selection.

This is the natural and appropriate endeavour for the enterprising investor.

Benjamin Graham regrets that he has little concrete guidance to offer the enterprising investor in this field.

The exercise of specialized foresight, the weighing of future probabilities and possibilities are not to be learned out of books - nor can they be aided much by suggested rules and techniques.

Elaborate study of the life cycle of industries and discussing a number of "symptoms of decay"; by noticing of which the alert investor may escape out of a once expanding industry before it is too late.

These suggested techniques require more ability and application than most investors can bring to bear on the problem.

[It is debatable whether once an industry has turned downward, it will never recover and that all securities within it must be permanently avoided.]



More guidance on Growth Stock Investing

The stock of a growing company, if purchasable at a suitable price, is obviously preferable to others.

No matter how enthusiastic the investor may feel about the prospects of a particular company, however, he should set a limit upon the price that he is willing to pay for such prospects.

• Such a rule would result at times in the missing of an unusually good opportunity. 
• More often, it would mean the investor's saving himself from "going overboard" on an issue that looked especially good to him and everyone else and consequently was selling much too high.

An illustration of investing in growth stocks

Two highly successful enterprises and both were considered to have excellent prospects of long-term growth.  Both were priced at 22 times that year's earnings.  The average price of Company A in 1939 was 62 and the price of company B in 1939 was 42.  The ordinary investor was as likely to buy one issue as the other.

Company A 's earnings had risen from $2.9 per share in 1939 to $10.90 per share in 1947.  Its price was equivalent to 150 or much more than double its 1939 average.  In the same years, the profits of Company B had moved up from $1.89 to $2.13, in spite of the record prosperity of 1947 and its price had fallen from 42 to 29.


                       Company A        Company B               Company C
                       1939    1947       1939   1947               1939    1947

Price               62         150         42       29                        6      26
Earnings        2.9         10.9      1.89    2.13                  0.13     3.14
P/E                 22                        22


The choice between the attractive issue that turns out well and the one that does poorly is by no means easy to make in the growth-stock field.


At the same time, it might be interesting to add a third pharmaceutical Company C which was by no means well regarded in 1939 - for its average price was only 6 (as against 28 in 1929) and it paid no dividend.  On its past record it could not qualify at all as a growth issue.  Yet in 1947 its earnings were $3.14 per share as against only 13 cents in 1939, and its April price in 1948 had risen to 26 - a much better percentage gain than CompanyA's.

The best opportunity in the field of drug stocks turned out to be where it was least expected - an all too frequent happening.


Inferences from the above illustration for investing in Growth Stocks

• Superior results may be obtained in this field if the choices are competently made.
• Even with careful selection, some of the individual issues may fare relatively poorly.  Some may actually decline and others may have only slight advances
• Thus for good results in the growth stock field there is need not only for skillful analysis but for ample diversification as well.

Summary on investing in Growth Stocks

1. The enterprising investor may properly buy growth stocks.
2. He should beware of paying excessively for them.  He might well limit the price by some practical rule.
3. A growth stock program will not be automatically successful; its outcome will depend on the foresight and judgement of the investor or his advisors rather than on any  clear-cut methods of analysis.

Price to Book Value Ratio

Price to Book Ratio

P/BV ratio
= Market price of common stock / Book Value per share

Unless the market becomes grossly overvalued (1999 and 2000), most stocks are likely to trade at multiples of less than 3 to 5 times their book value.

There is usually little justification for abnormally high price to book value ratios - except perhaps for firms that have abnormally low levels of equity in their capital structures.

Other than that, high P/BV multiples are almost always caused by "excess exuberance."

As a rule, when stocks start trading at 7 or 8 times their book values, or more, they are becoming overvalued.




Investor Mistakes (Short-lived Growth)

So called value stocks are stocks that have low price to book ratios, and growth stocks are stocks that have relatively high price to book ratios.

Many studies demonstrate that value stocks outperform growth stocks, perhaps because investors overestimate the odds that a firm that has grown rapidly in the past will continue to do so (Short-lived Growth).

DCF analysis is the most popular valuation methodology today. Growth (or lack of it) is an integral to a valuation exercise.

Discounted Cash Flow analysis to determine Intrinsic Value

The value of a business, a share of stock, or any other productive asset is the present value of its future cash flows.

Discounted cash flow (DCF) analysis (intrinsic value principle of John Burr Williams) is the most popular valuation methodology today.

Its popularity, however, hides the important reality that value is easier to define than to measure (easier said than done).

The tools Graham (margin of safety principle) and Fisher (business franchise principle) developed remain crucial in this exercise.



Value stocks versus Growth stocks:  this distinction has limited difference.

One hazard of undue reliance on DCF analysis is a temptation to classify stocks as either value stocks or growth stocks.  It is a distinction with limited difference.

Value a business (or any productive asset) requires estimating its probable future performance and discounting the results to present value.

The probable future performance includes whatever growth (or shrinkage) is assumed.

So growth (or lack of it) is integral to a valuation exercise.

Investing is the deliberate determination that one pays a price lower than the value being obtained.

Only speculators pay a price hoping that through growth the value rises above it.



Conventional Value Investing = low P/E, low P/BV and high DY companies

Value investing is conventionally defined as buying companies bearing low ratios of price-to-earnings, price-to-book value, or high dividend yields.

But these metrics do not by themselves make a company a value investment.  It is not that simple.

Nor does the absence of such metrics prevent an investment from bearing a sufficient margin of safety and qualitative virtues to justify its inclusion in a value investor's portfolio.




Growth doesn't equate directly with value either.

Growing earnings can mean growing value.

But growing earnings can also mean growing expenses, and sometimes expenses growing faster than revenues.

Growth adds value only when the payoff from growth (revenue) is greater than the cost of growth (expenses).

A company reinvesting a dollar of earnings to grow by 99 cents is not helping its shareholders and is not a value stock, though it may be a growth stock.




Read also:

Value Vs Growth

http://klse.i3investor.com/blogs/kcchongnz/45456.jsp

What drives the return of your stock investment, Growth or Value?

http://klse.i3investor.com/blogs/kcchongnz/81690.jsp

“In our opinion, the two approaches (value and growth) are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive…In addition, we think the very term “value investing” is redundant. What is “investing” if it is not the act of seeking value at least sufficient to justify the amount paid?”      Warren Buffett Letters to investor, 1992.

The preferred stocks to own - Growth Stocks at suitable prices. Do not overpay to own them.

The stock of a growing company, if purchasable at a suitable price, is obviously preferable to others.

The choice between the attractive issue that turns out well and the one that does poorly is by no means easy to make in the growth-stock field.

However, superior results may be obtained in this field if the choices are competently made.  

Even with careful selection, some of the individual issues may fare relatively poorly. 

Growth Stock Approach

Every investor would like to select a list of securities that will do better than the average over a period of years.  A growth stock may be defined as one which has done this in the past and is expected to do so in the future.

(A company with an ordinary record cannot, without confusing the term, be called a growth company or a "growth stock" merely because its proponent expects it to do better than the average in the future.  It is just a "promising company.")

Thus it seems only logical that the intelligent investor should concentrate upon the selection of growth stocks.
Actually the matter is more complicated.

The pursue of this aspect of investment policy require more ability and application than most investors can bring to bear on the problem.

The stock of a growing company, if purchasable at a suitable price, is obviously preferable to others.

No matter how enthusiastic the investor may feel about the prospects of a particular company, however, he should set a limit upon the price that he is willing to pay for such prospects.

In the case of a growth company, we should recommended payment of a premium for the growth potential not to exceed about 50% of the value determined without it.  

Such a rule would result at times in the missing of an unusually good opportunity.

More often, it would mean the investor's saving himself from "going overboard" on an issue that looked especially good to him and everyone else and consequently was selling much too high.

The choice between the attractive issue that turns out well and the one that does poorly is by no means easy to make in the growth-stock field.

However, superior results may be obtained in this field if the choices are competently made.  Even with careful selection, some of the individual issues may fare relatively poorly.  

Thus for good results in the growth-stock field there is need not only for skillful analysis but for ample diversification as well.



Summary

The enterprising investor may properly buy growth stocks.

He should beware of paying excessively for them, and he might well limit the price by some practical rule.

A growth-stock program will not be automatically successful; its outcome will depend on the foresight and judgement of the investor or his advisers rather than on any clear-cut methods of analysis.


Benjamin Graham
Intelligent Investor

Behaviour of Growth Stocks

A growth stock is identified as such because it has an especially satisfactory past record coupled with the expectation that this will continue.

It is the inherent nature of corporate growth eventually to taper off or to cease entirely.

Thus, if the stock market possessed the penetrating qualities popularly accorded to it, many growth stocks would begin to lose their high price level some time BEFORE any decline in their earning power had become apparent.

What seems to happen, rather, is that the price remains high UNTIL the earnings ACTUALLY show a definite falling off - which invariably seems to take the followers of the issue by surprise.

Then we have the market decline usually associated with a disappointing development - a decline perhaps intensified by the fact that the price level of the growth stock had been dangerously high.

Sometimes, either because of a certain stubbornness or a real insight into the long term future on the part of the investors, the price of such a deteriorated growth stock remains higher than its current performance would justify.

The growth stock principle of investment carries with it a real danger of miscalculations.  The average investor is likely to be most enthusiastic about such companies at the wrong time.  

Past trends are generally an unsound basis for investment decision.


Benjamin Graham

Introduction to a Value Investing Process by Bruce Greenblatt at the Value Investing Class Columbia Business School

When you are considering buying growth stocks:

 

1.  Verify the existence of a franchise

2.  Earnings return is 1/P/E.

3.  Identify cash distribution in terms of dividends and buybacks

4.  Identify investment return of retained earnings

5.  Identify organic (low investment growth)

6.  Compare to the market (representing D/P & growth rate) - is this positive or negative?

I will give you the numbers from three years ago which we applied to a bunch of firms.  
We will look at WMT, AMEX, DELL and GANNETT. 


Company        Business                                                   Adjusted ROE
WMT              Discount Rate                                             22.5%
AMEX            High-end CC                                              45.5%
Gannett           Local NP & Broadcasting                          15.6%
Dell Direct      P/C Supply & Logistics Organization       100% 


Company          Sources of CA                          Local Economies of Scale
WMT                Slight customer captivity            Yes
AMEX              customer captivity                       Some
Gannett             customer captivity                        Local
Dell                   Slight customer captivity             Yes 


Perspective Return on the US Market 

(1) 6% return based on (1/P/E) plus 2% inflation = 8%
(2)  2.5% (Dividends/price) plus 4.7% growth = 7.2% return 

Expected Return equals 7%.   Range is 7% to 8%.  

Wal-Mart. Dell, Gannett and AMEX.

If you are thinking of investing in them, what do you want to know first? 

Is there a franchise here?

• Does WMT have CA? Yes, regional dominance and it shows up in ROE, adj. for cash of 22%. 
• Amex is dominant in their geographic and product segments. Amex dominates in high end credit cards.  
• Gannett is in local newspapers. ROC is 15.6% if you took out goodwill then ROIC would be 35% or higher.  -- 

Ross: CA can’t be just sustained, allow to grow.  CA, EOS and CC.  

Do you think different type of CA are better for allowing you to grow.  They are therefore worth looking at?  Are those franchises sustainable. 

 

With WMT there is some customer captivity in retail but there are big local and regional Economies of Scale.

• When WMT goes outside these Economies of scale they have no advantages. 
• If they go against competitors outside their regional dominance, they will be on the wrong side of the trade.  

AMEX dominates high end credit cards. 

• Do they have customer captivity? 
• (Note: Amex has been using more and more debt to generate high ROE, so the risk profile is higher). 

Comparison to the Market

• They track well because if you look at reinvestment returns, it is high because people are not investing a lot in equities. 
• Look at organic growth which is higher than it is today. 
• On the other hand, multiples have gone up. 
• There has been a secular increase in multiples of 1% to 2%.
• You have to ask yourself, is it reasonable to earn a 7% to 8% return on equities in the present climate where long bonds are earning 4%?  Historically the gap has been 8%.  

Should you use a cost of equity of 7% to 9% vs. 9% to 11%.  I think that we are talking about real assets.  That is a good question. 

• One of the things you want to do is use a lower cost of capital than 9%.
• But all of a sudden all these stocks have EPV well above their asset values. 
• Now some of that will be in intangibles.

But what should be happening?  Investment should be going up, but they are not.

• So it looks like for practical purposes with a market multiple of 16 and 2x book value, the real returns are significantly lower than that.  
• So if you have the opportunity to invest in businesses with returns greater than that, you want to value the income streams at 9% to 11% rather than 7% to 9%. 

Amex is trading back at 17 times.  Growth rate at 15%.  A classic growth stock.

• A 6% return. 
• They are committed to returning 6% to shareholders, but the 6% cash distribution will be 4%.
• They are reinvesting 2%.
• We know what they are doing with that money. They are lending it to their customers, by and large.            

 

 

Notes from video lecture by Prof Bruce Greenwald
http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf

     

 

Calculating investment returns from growth stocks - returns from dividends and share buybacks, returns from retained earnings (reinvestment by the company) and returns from organic growth.

The calculation in the short run is not that hard to do.

1.  First you have to know where the money is going.

• Is WMT expanding in Mexico or is WMT expanding somewhere in Europe where it has no competitive advantages. 
• You can look at the simple economics with and without infrastructure costs and you see the returns if they have to build the infrastructure are about 7% to 8% which is below their cost of capital (Kcost). 
• If they can add stores to an existing infrastructure (stores near existing supply depots and other WMT stores), then the returns are more like 17% to 20%.
• But you ought to know enough about the economics of growth stocks, so you know those numbers. 

2.  You know what the reinvestment return is. 

• If the return is 20% after tax and their cost is 10%, what each dollar they reinvest worth?   $2 because they are earning 2x the cost of capital.  
• So what you are going to do is take that reinvestment return—that 5% that is reinvested and multiply it by the difference between the capital return and cost of capital.
• If they are earning 7% and Kcost is 10%, they are destroying at the rate of 3%.

3.  Is reinvesting in cash a good idea—no.

• A crappy return. 
• The longer they hold that cash the lower the return is in terms of reinvestment.   
• You are losing the return on that cash. 

So you look at the earnings return, what you get in cash, the fraction that is distributed either through buy backs and dividends and the fraction that is reinvestment and the value creation characteristics of the reinvestment.    

 

4.  Then certain companies get returns essentially without much investment--which is that if you own a franchise, even without conscious expansion, that franchise will sometimes grow.   The incremental investment involved is negligible. 

• When WMT sees an increase in SSS, it typically doesn’t have to build any new stores. 
• Especially if it is a price increase, its doesn’t have to add new people or add SKUs.
• What is the capital investment required for that increase in sales?  Only inventory.
• If their inventory turns are 8 times, then for every $1 of sales, they make about 7.5 cents in profit.
• That organic growth generates returns of about 16%. 
• They are higher than that in reinvestment because typically they will refinance two-thirds of the inventory investment with debt.
• So you will be getting returns of 150% on the capital you invest to support that organic growth. 

Why don’t returns get bid away by entrants whose store economics have improved?  That is where the existence of a franchise is crucial. If there were no barriers to entry, then gains would be get competed away by additional competitors.  So it is only growth behind those barriers that creates value.  

 

5.   You want to look next—you have your cash return, your investment return and then the return from organic growth and compare that to the return of the market to get a feel for your margin of safety is in terms of returns–then you want to see what will change that picture in a sustainable way.

 

 

Recap: 
Verify the existence of a franchise

Cash earnings return is 1/P/E.

Identify Cash distribution in terms of dividends and buybacks

Identify organic (low investment growth)

Identify investment return-multiple a percent of retained earnings

Compare to the market representing D/P & growth rate.

Identify options positive and negative.


Notes from video lecture by Prof Bruce Greenwald
http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf

Growth creates value only when the company has a competitive advantage. If there were no barriers to entry, then gains would be get competed away by additional competitors.

Why don’t returns get bid away by entrants whose store economics have improved? 

• That is where the existence of a franchise is crucial.
• If there were no barriers to entry, then gains would be get competed away by additional competitors. 
• So it is only growth behind those barriers that creates value.  

When you look at growth, this is what you look at: 
1.  First is verify the franchise.  If you don’t have a franchise, then growth is worth $0.

• Look at historical returns, share stability. 
• Look for sustainable competitive advantages. 

2.  Then calculate a return. 

• You don’t look at a P/E ratio, you look at an earnings ratio.
• If you are paying 14x earnings, it is a 7% if that P/E ratio stays the same and the earnings stay the same. You pay 11 times, it is 9%. 8 times, then 12.5%.  

3.   Out of that return there are two things that can happen to you—the first is that give it to you in your hot little hand in cash. What are you getting in cash?

• If it is a 8 times multiple, it is a 12.5% return.   
• The dividend is 2.5% and you are buying back 5% in stock per year, you are getting 7.5% in your hot little hand.
• If dividends and buyback policies are stable, then what are you getting.
• There are not stable then you have to estimate what they will be over time.  
• But you want to know what fraction of the earnings get distributed.
• So if 11 times multiple and they historically distribute a third of the earnings, 1/11 is a 9% and 1/3 of that is a 3% distribution. 

4.  What happens to the other 6%?  

• That gets reinvested—there the critical thing about the value is how effective do they reinvest that money?
• So in growth stocks, capital allocation is critical.
• Because (mgt.) is typically keeping most of your money and you care about how effectively they are investing it.      

5.  You want to look next—you have your cash return (3), your investment return (4) and then the return from organic growth.

 

6.  Compare that to the return of the market to get a feel for your margin of safety is in terms of returns–then you want to see what will change that picture in a sustainable way.  

 

 

Recap:  When you are considering buying growth stocks:

 

1.  Verify the existence of a franchise

2.  Earnings return is 1/P/E.

3.  Identify cash distribution in terms of dividends and buybacks

4.  Identify investment return of retained earnings

5.  Identify organic (low investment growth)

6.  Compare to the market (representing D/P & growth rate) - is this positive or negative?

 

 

 

Explanatory notes:

 

Dividends, buybacks & reinvestment of retained earnings:  So you look at the earnings return, what you get in cash, the fraction that is distributed either through buy backs and dividends and the fraction that is reinvestment and the value creation characteristics of the reinvestment.     

Organic growth:  Then certain companies get returns essentially without much investment--which is that if you own a franchise, even without conscious expansion, that franchise will sometimes grow.   The incremental investment involved is negligible.

 

 

 

Notes from video lecture by Prof Bruce Greenwald
http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf

The Growth Stocks of Peter Lynch

Peter Lynch

From 1977 through his retirement in 1990, Peter Lynch steered the Fidelity Magellan Fund to a total return of 2,510%, or five times the approximate 500% return of the Standard & Poor's 500 index. In his 1989 book One Up on Wall Street, Lynch described a variety of strategies that individual investors can use to duplicate his success. These strategies divide attractive stocks into different categories, each characterized by different criteria. Among those most easy to identify using quantitative research are fast growers, slow growers and stalwarts, with special criteria applied to cyclical and financial stocks. (The latter, for example, should have strong equity-to-assets ratios as a measure of financial solvency.)

Peter Lynch's Company Categories:

Fast Growers

These companies have little debt, are growing earnings at 20% to 50% a year, and have a stock price-to-earnings ratio below the company's earnings growth rate.

Investing in these types of stocks makes sense for investors who want to find solidly financed, fast-growing companies at reasonable prices.

Slow Growers

Here Lynch is looking for companies with high dividend payouts, since dividends are the main reason for investing in slow-growth companies.

Among other things, he also requires that such companies have sales in excess of $1 billion, sales that generally are growing faster than inventories, a low yield-adjusted price/earnings-to-growth ratio, and a reasonable debt-to-equity ratio.

Investing in these types of stocks makes sense for income-oriented investors.

Stalwarts

Stalwarts have only moderate earnings growth but hold the potential for 30%-to-50% stock price gains over a two-year period if they can be purchased at attractive prices. 

Characteristics include positive earnings; a debt to equity ratio of .33 or less; sales rates that generally are increasing in line with, or ahead of, inventories; and a low yield-adjusted price/earnings-to-growth ratio. 

Investing in these types of stocks makes sense for investors who aren't willing to pay up for high-growth companies but still want the chance to enjoy significant capital gains.

Read more: http://www.nasdaq.com/investing/guru/guru-bios.aspx?guru=lynch#ixzz2fsOsMVsc

Philip Fisher 15 Points for Growth Stocks

Peter Lynch's Investment Principles

The Reasons You Should Invest in Quality Growth Companies for the Long Term

The reasons you should review your philosophy and strategy in stock investing:

1.  You can create wealth only by adding value to resources or by providing a service of value.
2.  Only investments in active businesses are capable of adding value.
3.  Owning a business, though very rewarding, is expensive and risky; but owning shares in a variety of successful businesses eliminates most of the risk while retaining most of the reward.
4.  Buying the stock of quality growth companies and holding it for the long term provides substantial, predictable returns.
5.  Short term trading (BFS/STS) is unpredictable and stacks the odds against you, because it relies upon winning at some loser's expense and because there's no assurance that you won't be the loser.
6.  The benefits of long-term investing include carefree portfolio maintenance, the potential to double your money every five years, the deferment of taxes, and the fact that there are rarely any losers.



Let's review the simple mathematics that makes this method work:

1.  Assume that 15 times earnings is a fair multiple for a good company and that the company earned a dollar per share last year.
2.  You will therefore pay $15 for the stock.
3.  In five years, the earnings will have grown to $2 per share.
4.  At 15 times earnings, the price will then be $30.

The value of your investment will have doubled - in five years!


Hopefully you're satisfied with the logic behind this investing approach and can see its advantages.  

Let's dispel any doubts you might have about whether you can be successful.



The best way to minimize the risk is to invest in good quality companies for the long-term, expecting not to make a killing but to earn as much as good quality companies are capable of earning for their shareholders.

A rapidly growing company presents special problems in valuation.

A rapidly growing company presents special problems in valuation. John Burr Williams (1938:560) succinctly writes "They had high hopes for their business, but no logical evaluation of these hopes in terms of stock prices. The very fact that [the company] was one of the hardest of all stocks to appraise rationally was the reason why it sold at the most extravagant prices, for speculation ever feeds on mystery, as we have seen before."

The problem with estimating an approximate appraisal value for rapidly growing companies is presented most clearly in the St. Petersburg Paradox. As David Durand wrote: "With growth stocks, the uncritical use of conventional discount formulas is particularly likely to be hazardous; for, as we have seen, growth stocks represent the ultimate in investments of long duration. Likewise, they seem to represent the ultimate in difficulty of evaluation." 

Do Not Overpay to Own a Company with Brilliant Prospects; Use the Vagaries of the Market to Play the Master Game of Buying Low and Selling High

Growth Stock Paradox: The more successful the company, the greater are likely to be the fluctuations in the price of its shares.

This leads us to a conclusion of practical importance to the conservative investor in common stocks.

• If he is to pay some special attention to the selection of his portfolio, it might be best for him to concentrate on issues selling at a reasonably close approximation to their tangible-asset value—say, at not more than one-third above that figure. 
• Purchases made at such  levels, or lower, may with logic be regarded as related to the company’s balance sheet, and as having a justification or support independent of the fluctuating market prices. 
• The premium over book value that may be involved can be considered as a kind of extra fee paid for the advantage of stock-exchange listing and the marketability that goes with it.

A caution is needed here.

• A stock does not become a sound investment merely because it can be bought at close to its asset value. 
• The investor should demand, in addition, a satisfactory ratio of earnings to price, a sufficiently strong financial position, and the prospect that its earnings will at least be maintained over the years. 

This may appear like demanding a lot from a modestly priced stock, but the prescription is not hard to fill under all but dangerously high market conditions. 


Once the investor is willing to forgo brilliant prospects—i.e., better than average expected growth—he will have no difficulty in finding a wide selection of issues meeting these criteria.



More than half of the DJIA issues met our asset-value criterion at the end of 1970.

• The most widely held investment of all—American Tel. & Tel.—actually sells below its tangible-asset value as we write. 
• Most of the light-and power shares, in addition to their other advantages, are now (early 1972) available at prices reasonably close to their asset values. 

The investor with a stock portfolio having such book values behind it can take a much more independent and detached view of stock-market fluctuations than those who have paid high multipliers of both earnings and tangible assets.


As long as the earning power of his holdings remains satisfactory, he can give as little attention as he pleases to the vagaries of the stock market. 

More than that, at times he can use these vagaries to play the master game of buying low and selling high.

Explanations for the Erratic Price Behaviour of some of the Most Successful and Impressive Enterprises

Growth Stock Paradox: The more successful the company, the greater are likely to be the fluctuations in the price of its shares.

The argument made above should explain the often erratic price behavior of our most successful and impressive enterprises. 

• Our favorite example is the monarch of them all—International Business Machines. The price of its shares fell from 607 to 300 in seven months in 1962–63; after two splits its price fell from 387 to 219 in 1970. 
• Similarly, Xerox—an even more impressive earnings gainer in recent decades—fell from 171 to 87 in 1962–63, and from 116 to 65 in 1970. 

These striking losses 

• did not indicate any doubt about the future long-term growth of IBM or Xerox; 
• they reflected instead a lack of confidence in the premium valuation that the stock market itself had placed on these excellent prospects.

Growth Stock Paradox: The more successful the company, the greater are likely to be the fluctuations in the price of its shares.

The development of the stock market in recent decades has made the typical investor

• more dependent on the course of price quotations and 
• less free than formerly to consider himself merely a business owner. 

The reason is that the successful enterprises in which he is likely to concentrate his holdings

• sell almost constantly at prices well above their net asset value (or book value, or  “balance-sheet value”). 
• In paying these market premiums the investor gives precious hostages to fortune, for he must depend on the stock market itself to validate his commitments.†

This is a factor of prime importance in present-day investing, and it has received less attention than it deserves. The whole structure of stock-market quotations contains a built-in contradiction. 

• The better a company’s record and prospects, the less relationship the price of its shares will have to their book value. 
• But the greater the premium above book value, the less certain the basis of determining its intrinsic value—i.e., the more this “value” will depend on the changing moods and measurements of the stock market.  

Thus we reach the final paradox, that the more successful the company, the greater are likely to be the fluctuations in the price of its shares. 

• This really means that, in a very real sense, the better the quality of a common stock, the more speculative it is likely to be—at least as compared with the unspectacular middle-grade issues.*  
• (What we have said applies to a comparison of the leading growth companies with the bulk of well-established concerns; we exclude from our purview here those issues which are highly speculative because the businesses themselves are speculative.)

† Net asset value, book value, balance-sheet value, and tangible-asset value are all synonyms for net worth, or the total value of a company’s physical and financial assets minus all its liabilities. It can be calculated using the balance sheets in a company’s annual and quarterly reports; from total shareholders’ equity, subtract all “soft” assets such as goodwill, trademarks, and other intangibles. Divide by the fully diluted number of shares outstanding to arrive at book value per share.



* Graham’s use of the word “paradox” is probably an allusion to a classic article by David Durand, “Growth Stocks and the Petersburg Paradox,” The Journal of Finance, vol. XII, no. 3, September, 1957, pp. 348–363, which compares investing in high-priced growth stocks to betting on a series of coin flips in which the payoff escalates with each flip of the coin. Durand points out that if a growth stock could continue to grow at a high rate for an indefinite period of time, an investor should (in theory) be willing to pay an infinite price for its shares. Why, then, has no stock ever sold for a price of infinity dollars per share? Because the higher the assumed future growth rate, and the longer the time period over which it is expected, the wider the margin for error grows, and the higher the cost of even a tiny miscalculation becomes. 


Ref:  Intelligent Investor by Benjamin Graham