Advantages of Long Term Investing into Growth Stocks

Advantages of Long Term Investing into Growth Stocks

80% Success with Stock Selection
15% Annual Portfolio Return
Simple Procedures
Carefree Portfolio Maintenance




KISS Investing (Kiss It Simple and Safe)

1. You buy a company earning $1 per share ($1 EPS)

2. You buy that share for 20 X EPS ($1.00) = $20.00

3. The company grows earnings to $2 per share (EPS = $2)

4. You still sell it for 20 X EPS (20 X $2 =$40)

5. It's worth $40 and your money has doubled!

That's the secret.



The Two Most Important Tests of a Company's Value

1. What is the potential reward?

2. How much risk must I take to obtain it?



The Only Two Times You Should Sell a Stock

1. You want or need the money.

2. The company fails to perform as you predicted.

"Fails to perform as you predicted" means the quality deteriorates or the return potential deteriorates.

You hold a quality stock until you want or need the money unless the quality or potential return deteriorates.

Approximately one in five of the stocks you pick will develop unforeseen problems and need to be sold.



The Two Strategies of Portfolio Management

1. Defense - Has the quality deteriorated?

2. Offense - Has the return potential deteriorated?

Defensive portfolio management deals with making sure the growth you found and forecast is actually occuring. There will always be short term interuptions in growth which result in buying opportunities, but stocks with long term, serious problems must be caught early and delt with decisively by selling them.

Offensive portfolio management deals with grossly overvalued situations and is less urgent to pursue. Here your focus is to capture excess profit when a stock temporarily becomes overvalued by REPLACING it with another stock of equal or grater quality and greater return potential.

Missing a defensive portfolio management problem can result in serious harm to the return of your portfolio, whereas missing an offensive portfolio management problem only results in a little lost extra profit. You'll still own a quality stock.



Speculation vs. Investing

The difference between a speculator or day-trader and an investor.

A graph shows several years of weekly high - low price changes for a company that has been steadily growing its sales and earnings.

There was a lot of price fluctuations on a week to week basis, but the trend was clear. The price went up over the long term. Price follows earnings.

Speculators or day-traders try to predict the short term price directions and prosper by buying low and selling high. They don't need growth stocks. Long term investors do.

Long term investors use strategies to find these growth stocks and then pick purchase entry points and ride the long term upward trend in price.

Valuing High Growth Companies

The recommended standard valuation principles apply to high-growth companies too.

There is a difference in the order of the steps of the valuation process and the emphasis on each step.

1.  The analyst should forecast the development of the company's markets and then work backward.

2.  The analyst should create scenarios concerning the market's possible paths of development.

3.  When looking into the future, the analyst should also estimate a point in time at which the company's performance is likely to stabilize and then work backward from that point.

4.  By then, the company will have captured a stable market share; and one part of the forecasting process requires determining the size of the market and the company's share.

5.  Then, the firm must estimate the inputs for return:  operating margins, required capital investments, and ROIC.

6.  Finally, the analyst should develop scenarios and apply to the scenarios a set of probability weights consistent with long-term historical evidence on corporate growth.




########################

Time  ------->

Today ..... Rapid Growth ...... Growth Stabilizes .......

Today .....Growing Market Share .....Stable Market Share

Today..... How big is the market? .... How big is the market and the company's share?


Calculating the return:

1.  What is its total revenue?
2   What are its operating margins?
3.  What are its net operating profit after adjusting for tax?
4.  What are its capital investments?
5.  Calculate its ROIC

Industry Life-Cycle Analysis

Stages of Life-Cycle of Business / Industry

• Embryonic
• Growth
• Shakeout
• Mature
• Decline

Embryonic

Industries in this stage are just beginning to develop.

They are characterised by:

• Slow growth as customers are still unfamiliar with the product.
• High prices as volumes are too low to achieve significant economies of scale.
• Significant initial investment.
• High risk of failure.

Companies focus on raising product awareness and developing distribution channels during this stage.

Growth

Once the new product starts gaining acceptance in the market, the industry experiences rapid growth.

The growth stage is characterised by:

• New customers entering the market, which increases demand.
• Improved profitability as sales grow rapidly.
• Lower prices as econmies of scale are achieved.
• Relatively low competition among companies in the industry as the overall market size is growing rapidly.  Firms do no need to wrestle market share away from competitors to grow.
• High threat of new competitors entering the market due to low barriers to entry.

During this stage, companies focus on building customer loyalty and reinvest heavily in the business.

Shakeout

The period of rapid growth is followed by a period of slower growth.

The shakeout stage is characterised by:

• Slower demand growth as fewer new customers are left to enter the industry.
• Intense competition as growth becomes dependent on market share growth.
• Excess industry capacity, which leads to price reductions and declining profitability.

During this stage, companies focus on reducing their costs and building brand loyalty.

Some firms may fail or merge with others.

Mature

Eventually demand stops growing and the industry matures.

Characteristics of this stage are:

• Little or no growth in demand as the market is completely saturated.
• Companies move towards consolidation.  They recognize that they are interdependent so they stay away from price wars  However, price wars may occur during downturns.
• High barriers to entry in the form of brand loyalty and relatively efficient cost structures.

During this stage, companies are likely to be pursuing replacement demand rather than new buyers and should focus on extending successful product lines rather than introducing revolutionary new products.

Companies have limited opportunities to reinvest and often have strong cash flows.  

As a result, they are more likely to pay dividends.

Decline

Technological substitution, social changes or global competition may eventually cause an industry to decline.

The decline stage is characterised by:

• Negative growth
• Excess capacity due to diminishing demand.
• Price competition due to excess capacity.
• Weaker firms leaving the industry.

Limitations of Industry Life-Cycle Analysis

The following factors may

• change the shape of the industry life cycle, 
• cause some stages to be longer or shorter than expected, or 
• even result in certain stages being skipped altogether.

These factors are:

• Technological changes
• Regulatory changes
• Social changes
• Demographics

Industry life-cycles analysis is most useful in analyzing industries during periods of relative stability.

It is not as useful in analyzing industries experiencing rapid change.

Not all companies in an industry display similar performance.

Why buy growth?

Why are investors obsessed with growth?  

The answer is straightforward.

More than anything else, growth drives sustainable increases in earnings and cash flow.

And these factors determine a company's real worth and hence, its stock price.



What is growth?

When we talk about growth, we are basically talking about a company selling more goods ands services this year than it did last year, and expecting to sell even more the following year.

Increasing sales aren't the only way for a company to grow the bottom line.

It could, for a while at least, cut expenses and "do more with less."

It could buy back its own stock and decrease the denominator used in the earnings per share calculation (as long as this amount outweighs the loss of interest income from the money used to repurchase the share).

But there is only so much fat to trim, and if a company is going to see its profits - and ultimately its stock price rise over the long term, it must grow the top line.  



Why buy growth?

With the right principles and patience, you can hope to identify companies that are likely to turn a high growth rate - or an anticipated high growth rate - into a sustainable force to drive future cash flow for a long time, thus giving you a huge payoff for your diligence and effort.

The shocking truth about growth investors ... is that they are right.

The shocking truth about growth investors

Growth investing and growth investors are dirty words to many value investors.  A focus on growth is often called the Greater Fool Theory, and study after study shows that growth investing performs badly when compared to value investing.

As a value investor, it’s easy to mock growth investors with reams of data and an air of self-satisfied superiority.  There is a slight problem though.  The shocking truth about growth investors is that they’re right.  Growth investing is a fantastic way to make money in the stock market, as long as you do it right.

Warren Buffett is a growth investor

Buffett is usually considered a value investor, and that’s because he is one.  But he’s also a growth investor, and with the help of Charlie Munger they pioneered a hybrid approach where they combined the best of both worlds – long-term growth companies bought at value investment prices.

It was Buffett’s focus on outstanding businesses which could grow both quickly and consistently that really took him to the top of the world’s richest people list.

The FTSE 100 as a long-term growth investment

As a UK investor my focus is always on beating the FTSE 100 in the long-run.  The FTSE 100 beats some 80% or so of private and professional investors alike, and so if I can beat the FTSE then I know I’m doing much better than the pros, which is always nice.

I also know that my time and efforts are not wasted, because any investor can invest in the FTSE at almost no cost in terms of either time or money.  If you are not beating the FTSE 100 then you are effectively wasting your time.

As a growth investment, the FTSE 100 typically grows both earnings and dividends faster than inflation, and it does so relatively consistently over the years.  That growth ultimately drives the index level higher, regardless of how pessimistic the market may be.

In order to beat the market, we need to turn our portfolios into supercharged versions of the index, with superior growth, superior yields and superior valuations.

We all want growth, but growth of what?

For me, the most important numbers that need to grow are revenues, earnings and dividends.

At the end of the day, it’s the earnings and dividends which set the range within which a share price will fall (exactly where it falls within that range is up to the market), and both of those ultimately derive from revenues.

Long-term growth is all that matters

Short-term growth, positive or negative, is mostly noise and is unlikely to provide any useful information to investors.  If you find yourself trying to make money out of the day-to-day news then you might have inadvertently become a trader rather than an investor.

When I’m talking about growth, I mean long-term growth over as long a period as you can sensibly get data for.  For me this means looking at 10 year data for every single company that I’m interested in, and if it doesn’t have 10 years of public data available, then I won’t touch it.

This means that Facebook was out of the question, no matter how attractive it may or may not have been.

Where to get your data

Getting data that goes back 10 years can be tricky, but it is available through services likeSharelockholmes, Morningstar Premium, ShareScope and Stockopedia.

You can also get the annual results yourself and copy the information into a document or spreadsheet and use that.  I like to get annual report data from investegate.co.uk because it has a nice, lightweight and fast interface and I’m used to using it.

One slightly odd feature is that nobody seems to provide revenue per share.  We always get earnings and dividends per share, but not revenue per share.

If you want revenue per share, as I do, then you can either ask a data provider to provide it or get hold of the number of shares outstanding figure for each company you’re interested in.  Just search the annual reports for ‘shares’ and it should appear somewhere.

Of course you can always get your initial data from my newsletter, the Defensive Value Report, which gives high level data such as PE10, G10 and yield (all of which I’ll cover in upcoming posts) for all FTSE 350 companies.

Okay, so let’s get into the details…

How to measure revenue growth

The simplest way to look at 10 year growth is to just compare the revenue per share figure from the latest annual report with the one from 10 years ago.

I’ve tried various combinations to find the most accurate and robust measure of long-term growth.  I’ve tried looking at the average of the growth from each individual year, or combining 10, 5 and 3 year growth rates, but after much experimentation it seems that a simple 10 year growth figure is as good as anything else for highlighting long-term growth companies.

One caveat with revenue is that some companies don’t have revenue numbers.  Depending on where you get your data you may not see revenue for banks, insurance companies and various other types of businesses.  In these cases you’ll just have to look through the annual reports to work out what the equivalent of revenue is.  For example, with insurance companies I use net written premium.

How to measure earnings growth

For earnings I prefer to look at adjusted earnings.  The reason for this is that I’m looking to measure growth over time, so I need a reasonably smooth and less volatile number to measure, and adjusted earnings tend to be less volatile than basic earnings.

With basic earnings, even in very stable businesses you can have big changes in a single year, or even losses which will mess up any long-term growth calculation.  For example, if the loss doesn’t impact the company’s long-term earnings power.

Earnings power is a term that I like because it conveys the idea of a company’s ability to earn money, not just the actual amount that it earns in any one year.

If you look at BP for example, then the last 10 years basic earnings look like this:

So in 2010 there was a big loss in basic earnings.  If we were to take the 10 year growth figure in 2010 we’d have a negative 10 year growth number for that period, which would be hugely misleading.

This is less of a problem for revenues because that’s a more stable number and is never negative.  With dividends the problem does exist, but to a lesser extent because dividends are typically more stable than earnings.

By looking at adjusted earnings instead of basic earnings we can get a clearer picture of what the company is actually doing, and how the earnings power may be changing through the years.

But we can go a step further.  Ben Graham came up with a scheme for reducing the volatility of earnings even more, giving perhaps an even better picture of how the company’s earnings power is changing.

Graham simply took the latest 3 year average of earnings and compared that with the 3 year average from 10 years ago.

To get the 3 year average from 10 years ago you’d need the data going back 13 years (as the earlier average would be from years 13, 12 and 11).  If you only have access to 10 year data then you can just use the same system but just using the earliest 3 years that you have, which actually gives the 7 year growth rate between the two 3 year averages.

In the BP example above, we’d compare the average of 15.64, 22.88 and 36.48 (which is 25) to the average of 45.49, 77.48 and 79.04 (which is 67.34).

The growth over that period is 169%, according to my spreadsheet.

And talking of spreadsheets, if you want to know the annualised growth rate over that period you can just use the rate function in excel, which would look like this:

=RATE(7,,-100,269)

Where 7 is the number of years, -100 is the ‘present value’, and 269 is the future value (i.e. 100 plus the 169% increase).

The answer is that the 3 year earnings power of PB grew by an annualised rate of 15.2% per year in that 7 year period.

How to measure dividend growth

Like revenues, dividends are generally more stable than earnings, especially with the kind of large, market leading, relatively defensive companies that I’m interested in.

For that reason I generally just use the 10 year growth rate in the same was that I do for revenue.

However, I’m always experimenting with different ways of measuring past performance.  I want the most accurate and robust methods for finding companies that can grow quickly and consistently over many years.

That may mean that at some point I might change my dividend growth measure, and if it does it’s likely to change to the same approach that Ben Graham suggested for earnings.

Putting it all together

I call my growth metric G10, because otherwise it’s a massive mouthful to say that it’s the average of the 10 year growth of revenues, adjusted earnings and dividends, where the adjusted earnings growth is calculated as the growth between the latest 3 year average and the 3 year average from 7 years ago.

Just because this is a relatively complicated measure of growth, it doesn’t mean that it has magic powers.  It’s just as likely to throw up anomalies and rubbish companies as any other numbers based approach.

However, it’s a sensible first step towards finding companies that can grow earnings and dividends faster than the market, consistently and over long periods of time.

What it doesn’t really address is consistency.  So for consistency I have a separate metric which I’ll cover in my next post.

http://www.ukvalueinvestor.com/2012/07/the-shocking-truth-about-growth-investors.html/?utm_source=UK+Value+Investor+Weekly+Newsletter&utm_campaign=b0bc20d760-UK_Value_Investing_Weekly7_14_2012&utm_medium=email

Five Basic Fundamental Investing Principles

History has demonstrated that there are five basic principles that 
you should follow if you want to be truly successful.

Invest Regularly in the Stock Market

Reinvest all of Your Profits and Dividends

Invest for the Long Term

Invest Only in Good Quality Growth Companies

Diversify Your Portfolio

Equity Investments - Analyzing a Company - Types of Stock

1. Growth Company and Growth StockA growth company is a company that consistently grows by investing in projects that will generate growth. A growth stock, however, is a stock that earns a higher rate of return over stocks with a similar risk profile.
   
   Feasibly, a company could be a growth company, but its stock could be a value stock if it is trading below its peers of similar risk.

2. Defensive Company and Defensive StockA defensive company is a company whose earnings are relatively unaffected in a business cycle downturn. A defensive company is typically reflective of products that we "need" versus "want". A food company, such as Kellogg, is considered a defensive company. A defensive stock, however, will hold its value relatively well in a business cycle downturn.

3. Cyclical Company and Cyclical StockA cyclical company is a company whose earnings are affected relative to a business cycle. A cyclical company is typically reflects products we "want". A retail store, such as The Gap, is considered a cyclical company. A cyclical stock, however, will move with the market in relation to the business cycle.

4. Speculative Company and Speculative Stock.A speculative company is a company that invests in a business with an uncertain outcome. An oil exploration company is an example of a speculative company. A speculative stock, however, is a stock that has potential for a large return, as well as the potential for considerable losses. An example of speculative stocks can be found in the tech bubble, where investors put money into speculative stocks, but the investor could have been hurt financially or made large gains depending on the stock the investor invested in.

Read more: http://www.investopedia.com/exam-guide/cfa-level-1/equity-investments/analyzing-companies-stock-types.asp#ixzz1yf8SKSRC

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

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


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

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

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


Just What Do We Mean by Growth?
As can be seen in the diagram above, a successful company will pass through several phases of growth:

• The startup phase when earnings are predictably below the break-even point. 
• A period of explosive growth when the percentage increase in sales and earnings can be spectacular.

• The mature growth period when revenue becomes so large that it is difficult to maintain a consistent increase in the percentage of growth.
• The period of stabilization, or decline for companies that do not continue to rejuvenate their product mix or expand their target markets.

You should invest only in companies that have a track record as a public company for at least five years and for which the data is readily available. We are therefore interested in investing in companies that are at least five years into their explosive growth periods but that have not gone past their primes. Obviously, the longer the company has had a successful track record—provided its management copes successfully with maturity—the more stable and risk-free it is apt to be.

Depending upon the size of the company, fundamental investors should expect growth rates that vary from a low of about 7% to a high of around 20%. 

• Hence, if the company is an established one with sales over the $5 billion mark, a growth rate of as little as 7% might be acceptable. (The Total Return of such a company should have a substantial dividend yield component.)
• At the other end of the spectrum, the newer company in its explosive growth period should show double digit growth. While we know that growth rates above 20% cannot be sustained forever, we look for higher growth rates as compensation for the increased associated risk.

The chart below provides a rough guideline for the kinds of growth rates that concept suggests. Anything in the light area is acceptable for companies whose revenues (sales) match the scale on the left side.



For example,

• if a company‘s sales for the current year are in the neighborhood of $300 million, we would look for a growth rate of better than 12%. 
• For a company with $1 billion in sales, we would want at least 8%. 

These are the standards of growth that we will seek for investment. Higher risk situations involving companies early in their life cycles are speculative and not of investment quality.

Warren Buffett interview on how he loves to do business

Listen to Warren Buffett's view on growth companies.

How to do a stock research & analysis.

Opto Circuits India Ltd - Stock Research & Analysis
(15 Dec 2008)

Synopsis

Opto Circuits is a small company in Medical Electronics industry with focus in the niche areas of invasive (coronary stents) and non-invasive (sensors, patient monitors) segments. Prior to '2002 Opto's Revenues were less than Rs. 50 Cr. Today Revenues stand at Rs.468 Cr, with exports accounting for more than 95% of Revenues. Opto Circuits is based in Bangalore India and operates out of offices established in USA, Europe, South-East Asia, Latin America and the Middle East and boasts of a strong international distribution network present in over 70 countries.

The Numbers speak for themselves. Net profit margins are healthy (over 28%), great return on equity (~ 40%, unmatched in the Medical Electronics industry), and solid return on invested capital ratios (over 45%). Financial health has been steadily improving over the years with comfortable financial leverage (1.34) and Debt to equity (0.31), with solid Current & Quick ratios. However, Opto Circuits still has a long way to go before it can show loads of excess cash on its books, due to its aggressive business expansion. Free Cash Flow as a percentage of sales is ~6 percent. It has consistently increased Dividends per share and has a unique track record of rewarding shareholders with bonus shares every year, for the 7th straight year! Opto Circuits seems to enjoy an above-average Economic Moat and fares very well when compared to its peers in this Peer Comparison snapshot.

Though there are Significant Risks going forward, Opto Circuits has lots of positives going for it. Over the last 7 years since FY2002, Opto Circuits Revenues have clocked a long term sales growth of over 45% while long term EPS growth has galloped at a handsome 60% plus. It has been working steadily grow its business through pursuing organic growth through investments in manufacturing capacities and penetrating into newer markets, supplemented by inorganic growth through judicious acquisitions. To its credit Opto circuits has managed acquisitions so far quite well, drawing synergies by leveraging distribution networks and lower-cost manufacturing bases. There is some evidence of Sustainable Growth over the medium term. We posed a few questions to Opto Circuits Management to be able to understand and assess its longer-term prospects and growth sustainability, better.

Opto's track record so far evidences early signs of being served by a Competent Management Team. The stock is promising and there's nothing wrong with investing in a young growth company like Opto Circuits, as long as you know what you are getting into. It has a long way to go before it qualifies to be among the Core holdings in anyone's Portfolio. It’s a long shot, though one that might just pay you back many times over. However, this is only half the story because even the best companies are poor investments if purchased at too high a price. We cover Opto Circuits' stock valuation in the other half story. 

Read more here:

http://www.stock-picks-focus.com/opto-circuits.html#Profitability-Snapshot

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

Characteristics of Growth Companies and their Value Drivers

Characteristics of growth companies

            Growth companies are diverse in size, growth prospects and can be spread out over very different businesses but they share some common characteristics that make an impact on how we value them. In this section, we will look at some of these shared features:

1. Dynamic financials: Much of the information that we use to value companies comes from their financial statements (income statements, balance sheets and statements of cash flows). One feature shared by growth companies is that the numbers in these statements are in a state of flux. Not only can the numbers for the latest year be very different from numbers in the prior year, but can change dramatically even over shorter time periods. For many smaller, high growth firms, for instance, the revenues and earnings from the most recent four quarters can be dramatically different from the revenues and earnings in the most recent fiscal year (which may have ended only a few months ago).
2. Private and Public Equity: It is accepted as conventional wisdom that the natural path for a young company that succeeds at the earliest stages is to go public and tap capital markets for new funds. There are three reasons why this transition is neither as orderly nor as predictable in practice. The first is that the private to public transition will vary across different economies, depending upon both institutional considerations and the development of capital markets. Historically, growth companies in the United States have entered public markets earlier in the life cycle than growth companies in Europe, partly because this is the preferred exit path for many venture capitalists in the US. The second is that even within any given market, access to capital markets for new companies can vary across time, as markets ebb and flow. In the United States, for instance, initial public offerings increase in buoyant markets and drop in depressed markets; during the market collapse in the last quarter of 2008, initial public offerings came to a standstill. The third is that the pathway to going public varies across sectors, with companies in some sectors like technology and biotechnology getting access to public markets much earlier in the life cycle than firms in other sectors such as manufacturing or retailing. The net effect is that the growth companies that we cover in chapter will draw on a mix of private equity (venture capital) and public equity for their equity capital. Put another way, some growth companies will be private businesses and some will be publicly traded; many of the latter group will still have venture capitalists and founders as large holders of equity.
3. Size disconnect: The contrast we drew in chapter 1 between accounting and financial balance sheets, with the former focused primarily on existing investments and the latter incorporating growth assets into the mix is stark in growth companies. The market values of these companies, if they are publicly traded, are often much higher than the accounting (or book) values, since the former incorporate the value of growth assets and the latter often do not. In addition, the market values can seem discordant with the operating numbers for the firm – revenues and earnings. Many growth firms that have market values in the hundreds of millions or even in the billions can have small revenues and negative earnings. Again, the reason lies in the fact that the operating numbers reflect the existing investments of the firm and these investments may represent a very small portion of the overall value of the firm.
4. Use of debt: While the usage of debt can vary across sectors, the growth firms in any business will tend to carry less debt, relative to their value (intrinsic or market), than more stable firms in the same business, simply because they do not have the cash flows from existing assets to support more debt. In some sectors, such as technology, even more mature growth firms with large positive earnings and cash flows are reluctant to borrow money. In other sectors, such as telecommunications, where debt is a preferred financing mode, growth companies will generally have lower debt ratios than mature companies.
5. Market history is short and shifting: We are dependent upon market price inputs for several key components of valuation and especially so for estimating risk parameters (such as betas). Even if growth companies are publicly traded, they tend to have short and shifting histories. For example, an analyst looking at Google in early 2009 would have been able to draw on about 4 years of market history (a short period) but even those 4 years of data may not be particularly useful or relevant because the company changed dramatically over that period – from revenues in millions to revenues in billions, operating losses to operating profits and from a small market capitalization to a large one. 

While the degree to which these factors affect growth firms can vary across firms, they are prevalent in almost every growth firm.

Growth companies- Value Drivers

Scalable growth

The question of how quickly revenue growth rates will decline at a given company can generally be addressed by looking at the company's specifics – the size of the overall market for its products and services, the strength of the competition and quality of both its products and management.  Companies in larger markets with less aggressive competition (or protection from competition) and better management can maintain high revenue growth rates for longer periods.

            There are a few tools that we can use to assess whether the assumptions we are making about revenue growth rates in the future, for an individual company, are reasonable:

1.     Absolute revenue changes: One simple test is to compute the absolute change in revenues each period, rather than to trust the percentage growth rate. Even experienced analysts often under estimate the compounding effect of growth and how much revenues can balloon out over time with high growth rates. Computing the absolute change in revenues, given a growth rate in revenues, can be a sobering antidote to irrational exuberance when it comes to growth.

2.     Past history: Looking at past revenue growth rates for the firm in question should give us a sense of how growth rates have changed as the company size changed in the past. To those who are mathematically inclined, there are clues in the relationship that can be used for forecasting future growth.

3.     Sector data: The final tool is to look at revenue growth rates of more mature firms in the business, to get a sense of what a reasonable growth rate will be as the firm becomes larger.

In summary, expected revenue growth rates will tend to drop over time for all growth companies but the pace of the drop off will vary across companies.

Sustainable margins

To get from revenues to operating income, we need operating margins over time. The easiest and most convenient scenario is the one where the current margins of the firm being valued are sustainable and can be used as the expected margins over time. In fact, if this is the case, we can dispense with forecasting revenue growth and instead focus on operating income growth, since the two will be the equivalent. In most growth firms, though, it is more likely that the current margin is likely to change over time.

            Let us start with the most likely case first, which is that the current margin is either negative or too low, relative to the sustainable long-term margin. There are three reasons why this can happen. One is that the firm has up-front fixed costs that have to be incurred in the initial phases of growth, with the payoff in terms of revenue and growth in later periods. This is often the case with infrastructure companies such as energy, telecommunications and cable firms. The second is the mingling of expenses incurred to generate growth with operating expenses; we noted earlier that selling expenses at growth firms are often directed towards future growth rather than current sales but are included with other operating expenses. As the firm matures, this problem will get smaller, leading to higher margins and profits. The third is that there might be a lag between expenses being incurred and revenues being generated; if the expenses incurred this year are directed towards much higher revenues in 3 years, earnings and margins will be low today.

            The other possibility, where the current margin is too high and will decrease over time, is less likely but can occur, especially with growth companies that have a niche product in a small market. In fact, the market may be too small to attract the attention of larger, better-capitalized competitors, thus allowing the firms to operate under the radar for the moment, charging high prices to a captive market. As the firm grows, this will change and margins will decrease. In other cases, the high margins may come from owning a patent or other legal protection against competitors, and as this protection lapses, margins will decrease. 

            In both of the latter two scenarios – low margins converging to a higher value or high margins dropping back to more sustainable levels – we have to make judgment calls on what the target margin should be and how the current margin will change over time towards this target. The answer to the first question can be usually be found by looking at both the average operating margin for the industry in which the firm operates and the margins commanded by larger, more stable firms in that industry. The answer to the second will depend upon the reason for the divergence between the current and the target margin. With infrastructure companies, for instance, it will reflect how long it will take for the investment to be operational and capacity to be fully utilized.

Quality Growth

A constant theme in valuation is the insistence that growth is not free and that firms will have to reinvest to grow. To estimate reinvestment for a growth firm, we will follow one of three paths, depending largely upon the characteristics of the firm in question:

1.     For growth firms earlier in the life cycle, we will adopt the same roadmap we used for young growth companies, where we estimated reinvestment based upon the change in revenues and the sales to capital ratio.

Reinvestment_t = Change in revenues_t/ (Sales/Capital)

The sales to capital ratio can be estimated using the company's data (and it will be more stable than the net capital expenditure or working capital numbers) and the sector averages. Thus, assuming a sales to capital ratio of 2.5, in conjunction with a revenue increase of $ 250 million will result in reinvestment of $ 100 million.  We can build in lags between the reinvestment and revenue change into the computation, by using revenues in a future period to estimate reinvestment in the current one.

2.     With a growth firm that has a more established track record of earnings and reinvestment, we can use the relationship between fundamentals and growth rates that we laid out in chapter 2:

Expected growth rate in operating income = Return on Capital * Reinvestment Rate + Efficiency growth (as a result of changing return on capital)

In the unusual case where margins and returns and capital have settled into sustainable levels, the second term will drop out of the equation.

3.     Growth firms that have already invested in capacity for future years are in the unusual position of being able to grow with little or no reinvestment for the near term. For these firms, we can forecast capacity usage to determine how long the investment holiday will last and when the firm will have to reinvest again. During the investment holiday, reinvestment can be minimal or even zero, accompanied by healthy growth in revenues and operating income.

With all three classes of firms, though, the leeway that we have in estimating reinvestment needs during the high growth phase should disappear, once the firm has reached its mature phase. The reinvestment in the mature phase should hew strictly to fundamentals:

Reinvestment rate in mature phase = 

In fact, even in cases where reinvestment is estimated independently of the operating income during the growth period, and without recourse to the return on capital, we should keep track of the imputed return on capital (based on our forecasts of operating income and capital invested) to ensure that it stays within reasonable bounds.

The Little Book of Valuation

Aswath Damodaran

Life Cycle of a Growth Stock (BBB)

What's Beyond for Bed Bath and Beyond?

Location: BlogsAsk Doug!      Posted by: Doug Gerlach 5/1/2007 3:17 PM It's certainly true that Bed Bath & Beyond's (BBBY) price hasn't shown any consistency in the past few years, bouncing between a low of $31.56 in March 2003 and a high of $46.00 in July 2005. While it's not uncommon for stock prices to get stuck in a rut, what's a bit unusual about Bed Bath & Beyond is that the stock's earnings and revenues have been getting continually larger. As you can see from the black price bars on the graph below, BBBY's stock price has stalled since 2003. So why hasn't the company's stock price risen along with sales and profits? One likely explanation is that the company is reaching a new stage in its company life cycle in which its EPS and Revenue growth rates will likely slow. BBBY's fiscal 2006 annual revenues were $6.6 billion, and opportunities for fast growth are harder to come by for a company of that size. Consider the following illustration of the typical life cycle of a company. Once a new company makes it through the initial startup stage and passes the break-even point, it can grow explosively, in excess of 30% or more a year. These fast-growing companies can be excellent investment opportunities, though often it's the momentum traders and short-term focused investors who make the markets for these stocks. These kinds of stocks are often richly valued, with PE Ratios that anticipate continuing growth at very high annualized rates, and, therefore, long-term, growth-oriented investors may not have many opportunities to buy them at reasonable prices. Ultimately, though, such rapid growth must ebb. It's simply impossible for a company to maintain such high growth on an indefinite basis. When investors begin to see that growth is slowing, they often jump ship, driving down the PE Ratio and causing the stock's price to stall. For BBBY, the signs of slowing growth actually began appearing several years ago. On the historical graph of revenues and earnings above, you can begin to see the slowdown most evidently in 2004, with annual high and low prices stalled in a range between $33 and $47. The average annual high and low PE Ratios have also been declining each year since 2002, too: the average high PE Ratio has fallen from 37.7 to 20.7 and the average low PE Ratio has fallen from 27.0 to 14.8. From a visual analysis of sales and earnings, it's not at all clear that the slowdown in growth and the falling prices and PE Ratios are so tightly connected. What's not apparent from the above graph is that the growth rates have been falling significantly for several years. Here is a graph of the historical growth rates for the past 1- to 9-year periods of the last decade. Now it's obvious that the growth of the past year is much, much lower than the 9-year annualized growth rate of the company for both EPS and Revenues. (Incidentally, this graph is from Investor's Toolkit 5.) In light of the slowing growth rates, you can see why some investors are a little reluctant to buy BBBY at the current situation. The company is in transition from being a 30% annual grower to one that grows at likely half that rate, and it can take the market several years to process the change as the company becomes a mature grower. BBBY's sheer size does brings new competitive pressures, and Wall Street's bulls and bears are happy to debate whether or not company management is up to the challenge. Even though margins fell from 15.8% to 14.1% in 2006, BBBY's pre-tax profit margins are excellent within the retail industry. The current trailing PE Ratio of 19.9 is right around my calculated signature PE for the company, indicating that the stock is reasonably valued right now assuming an annualized EPS growth no less than 15%. Of course, the assumption that BBBY's growth will stabilize somewhere between 15% and 20% annually is key to the attractiveness of the company's long-term prospects. Even if margins fall a bit and growth is at the lower end of the range, BBBY might still be a solid long-term core holding for a portfolio. Note: BBBY is currently rated a Buy up to $48 by the Investor Advisory Service. The comments above are Doug's alone, and do not represent the views of the independent analysts who cover BBBY for the IAS. http://webcache.googleusercontent.com/search?q=cache:http://www.stockcentral.com/tabid/159/EntryID/6/Default.aspx