Growth stocks as a class has a striking tendency toward wide swings in market price (II)

Growth stocks as a class has a striking tendency toward wide swings in market price (II)

https://myinvestingnotes.blogspot.com/2010/02/growth-stocks-as-class-has-striking.html

The striking thing about growth stocks as a class is their tendency toward wide swings in market price. But is it not true, that the really big fortunes from common stocks have been garnered by those who made a substantial commitment in the early years of a company in whose future they had great confidence and who held their original shares unwaveringly while they increased 10-fold or 100-fold or more in value? The answer is "Yes." But the big fortunes from single company investments are almost always realised by persons who have a close relationship with the particular company - through employment, family connection, etc. - which justifies them in placing a large part of their resources in one medium and holding on to this commitment through all vicissitudes, despite numerous temptations to sell out at apparently high prices along the way. An investor without such close personal contact will constantly be faced with the question of whether too large a portion of his funds are in this one medium. Each decline - however temporary it proves in the sequel - will accentuate his problem; and internal and external pressures are likely to force him to take what seems to be a good profit.

Based on the provided text, here is a summary:

The passage makes a key distinction between two types of successful growth stock investing:

1. The Reality of Growth Stocks: As a category, growth stocks are inherently volatile and prone to wide price swings.

2. The Source of "Big Fortunes": Truly large fortunes from single-company investments are almost exclusively made by insiders (e.g., employees, founders, family) who:

   • Have an intimate, justified confidence in the company.

   • Can commit a large portion of their wealth to it.

   • Hold their shares unwaveringly through all market fluctuations and temptations to sell.

3. The Challenge for the Outside Investor: An investor without this close personal connection faces significant psychological and practical pressures:

   • They will constantly worry about having too much concentrated in one risky asset.

   • Every price decline, even a temporary one, will intensify this doubt.

   • These pressures will likely force them to sell for a "good profit" long before the stock achieves its maximum, multi-fold growth potential.

In essence: While holding a single growth stock through immense volatility is how vast fortunes are built, this strategy is sustainable practically only for insiders. The typical outside investor is psychologically and rationally compelled to diversify and sell early, missing the largest gains.

Summary

In conclusion, the provided text highlights the core paradox of growth investing:

• As a class, growth stocks are characterized by high volatility ("wide swings in market price") due to their dependence on uncertain future prospects.

• However, the only way to capture the legendary, life-changing returns from the stock market is to identify specific companies from within this volatile class, invest meaningfully in them early, and possess the rare combination of foresight and fortitude to hold them through extreme market fluctuations until they multiply in value many times over.

The critical takeaway is that the second path, while true and proven by historical examples, is far more difficult, risky, and rare than the romantic narrative suggests. It is the exception, not the rule. For every investor who achieves a 100-bagger return, countless others see their early-stage "conviction" bets evaporate. Therefore, while the strategy of buying and holding growth stocks is a valid path to extreme wealth, it should be pursued with a clear understanding of the immense risks, the powerful role of luck, and the psychological challenges involved. For most, a diversified approach that acknowledges the "striking tendency" of growth stocks to be volatile may be a more prudent long-term strategy.

=====

There is a fundamental tension in growth investing. While the only proven way to achieve extraordinary wealth from stocks is to make a concentrated, early bet on a specific high-growth company and hold it through extreme volatility, this path is exceptionally rare and risky.

It emphasizes that for every legendary success, there are many failures. Therefore, while valid, this high-stakes strategy requires acknowledging immense risk, luck, and psychological fortitude. For most investors, a diversified approach is a more prudent and realistic alternative to chasing outsized returns from volatile growth stocks.

****Buffett (1992): Do not categorise stocks into growth and value types, the two approaches are joined at the hip

 

****Buffett (1992): Do not categorise stocks into growth and value types, the two approaches are joined at the hip

https://myinvestingnotes.blogspot.com/2010/04/buffett-1992-do-not-categorise-stocks.html

====

Here is a summary of Warren Buffett's key points from his 1992 shareholder letter:

Core Argument: The traditional division between "value" and "growth" investing is a false and unhelpful dichotomy. True investing is always about seeking value.

Key Takeaways:

1. Growth and Value Are Inseparable: Growth is a critical component in calculating a business's intrinsic value. Its impact can be positive, negative, or negligible, but it is always a variable in the valuation equation.

2. "Value Investing" is Redundant: All legitimate investing is the pursuit of value. Paying more for a stock than its calculated intrinsic value is speculation, not investing.

3. Surface Metrics Are Misleading: Traditional "value" indicators (low P/E, low P/B, high yield) or "growth" indicators (high P/E, high P/B) are not definitive. A stock with a high P/E can still be a "value" purchase if its intrinsic value is even higher.

4. Growth Alone Does Not Create Value: Growth only benefits investors when the business can generate returns on its incremental capital that exceed its cost of capital. Profitable growth that consumes vast amounts of capital can destroy shareholder value (e.g., the airline industry).

5. The Crucial Metric is Return on Capital: The primary determinant of value is not profit growth itself, but the amount of capital required to achieve that growth. The lower the capital consumed for a given level of growth, the higher the intrinsic value.

Practical Investor Lesson: Investors should avoid companies and sectors where fast profit growth is accompanied by low returns on capital employed (below the cost of capital). The focus must be on the relationship between growth, capital required, and the resulting returns.

Growth stocks as a class has a striking tendency toward wide swings in market price

  

Growth stocks as a class has a striking tendency toward wide swings in market price (II)

https://myinvestingnotes.blogspot.com/2010/02/growth-stocks-as-class-has-striking.html

The striking thing about growth stocks as a class is their tendency toward wide swings in market price.

But is it not true, that the really big fortunes from common stocks have been garnered by those 

• who made a substantial commitment in the early years of a company in whose future they had great confidence and 
• who held their original shares unwaveringly while they increased 10-fold or 100-fold or more in value?

The answer is "Yes."  

=====

This is a fascinating and central tension in investing philosophy, pitting the romantic ideal of the "visionary founder or early backer" against the cold, hard statistics of market behavior.

Let's break down the provided statements, elaborate, discuss, critique, and then summarize.

Elaboration and Discussion

The two paragraphs present two seemingly contradictory truths about growth stocks and wealth creation.

1. The General Rule (The "Striking Tendency"):

   • What it means: Growth stocks, as a category, are inherently volatile. Their prices are not tied to stable, current earnings but to expectations of future earnings. These expectations are based on narratives, forecasts, and sentiment, all of which can change rapidly.

   • Why it happens:

     • Speculative Fever: Good news can lead to euphoria, driving prices to unsustainable heights.

     • Disappointment & Fear: A single missed earnings target, a new competitor, or a shift in the economic landscape can shatter the narrative, leading to a brutal sell-off.

     • High Valuations: Since they often trade at high Price-to-Earnings (P/E) ratios, even small changes in future growth projections can lead to large swings in the present value calculation.

2. The Path to Extreme Wealth (The "Big Fortunes"):

   • What it means: The legendary returns in the stock market—the kind that create generational wealth—do not typically come from trading in and out of stocks. They come from identifying a truly exceptional company early and having the conviction to hold onto it through thick and thin, allowing the power of compounding to work over many years or decades.

   • Iconic Examples: Think of early investors in companies like Amazon, Apple, Tesla, or Microsoft. Those who held on through the dot-com bust, the 2008 financial crisis, and countless periods of doubt were rewarded with life-changing returns.

The Synthesis: These two ideas are not opposites; they are two sides of the same coin. The very volatility that defines the class of growth stocks is the price of admission for the astronomical returns of the few individual winners. The "wide swings" include the dramatic upward swings that create 100-baggers. You cannot have the latter without the former.

Critique and The Crucial Caveats

While the "buy, hold, and get rich" narrative is powerful and true in specific cases, it is critically important to understand its limitations and the survivorship bias it contains.

1. Survivorship Bias is Overwhelming:
   This is the most significant criticism. For every Amazon that succeeded, there are dozens of companies like Pets.com, Webvan, or countless other tech, biotech, and growth companies that failed completely or never lived up to their hype. We hear the stories of the winners; the losers are forgotten. The narrative asks "Is it not true that the really big fortunes...?" but ignores the more common question: "Is it not true that the really big losses have been garnered by those who made a substantial commitment in the early years of a company that ultimately failed?"

2. The Difficulty of "Great Confidence":
   Having "great confidence" in a company's future is easy in hindsight. In the present, it is exceptionally difficult to distinguish the next Apple from the next BlackBerry. Many companies that seemed like sure bets were disrupted by new technology or mismanagement. The business landscape is littered with "can't lose" companies that lost.

3. The Psychological Torture of "Holding Unwaveringly":
   Holding through a 50% or even 90% decline is emotionally devastating and goes against every human instinct for self-preservation. Most investors lack the temperament for it. Furthermore, during these "wide swings" downward, the financial media and your own brain will scream at you to sell. The few who succeed in holding are often either extraordinarily disciplined, oblivious, or the founders themselves who have inside information and control.

4. The Opportunity Cost:
   "Holding unwaveringly" requires immense patience and capital that is locked away for decades. During that time, an investor might miss other, more reliable compounding opportunities. A strategy of holding an S&P 500 index fund, while less glamorous, has proven to be a more consistent and less risky path to wealth for the average person.

5. The Question of "When to Sell":
   The narrative glorifies buying and holding but is silent on when, if ever, to sell. No company grows at an explosive rate forever. Eventually, most become large, mature, and slower-growing. Is it still the right move to hold? The 100-fold return in Microsoft from the 80s to the 2000s is legendary, but an investor who held from 2000 to 2013 would have seen zero price appreciation. Timing the exit, or at least rebalancing, is a complex part of the equation.

Summary

In conclusion, the provided text highlights the core paradox of growth investing:

• As a class, growth stocks are characterized by high volatility ("wide swings in market price") due to their dependence on uncertain future prospects.

• However, the only way to capture the legendary, life-changing returns from the stock market is to identify specific companies from within this volatile class, invest meaningfully in them early, and possess the rare combination of foresight and fortitude to hold them through extreme market fluctuations until they multiply in value many times over.

The critical takeaway is that the second path, while true and proven by historical examples, is far more difficult, risky, and rare than the romantic narrative suggests. It is the exception, not the rule. For every investor who achieves a 100-bagger return, countless others see their early-stage "conviction" bets evaporate. Therefore, while the strategy of buying and holding growth stocks is a valid path to extreme wealth, it should be pursued with a clear understanding of the immense risks, the powerful role of luck, and the psychological challenges involved. For most, a diversified approach that acknowledges the "striking tendency" of growth stocks to be volatile may be a more prudent long-term strategy.

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 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.

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

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." 

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

Margin of Safety Concept in Growth Stocks

The philosophy of investment in growth stocks parallels in part and in part contravenes the margin-of-safety principle.

• The growth-stock buyer relies on an expected earning power that is greater than the average shown in the past.
• Thus he may be said to substitute these expected earnings for the past record in calculating his margin of safety.
• In investment theory there is no reason why carefully estimated future earnings should be a less reliable guide than the bare record of the past; in fact, security analysis is coming more and more to prefer a competently executed evaluation of the future.
• Thus the growth-stock approach may supply as dependable a margin of safety as is found in the ordinary investment— provided the calculation of the future is conservatively made, and provided it shows a satisfactory margin in relation to the price paid.

The danger in a growth-stock program lies precisely here.

• For such favored issues the market has a tendency to set prices that will not be adequately protected by a conservative projection of future earnings.
• (It is a basic rule of prudent investment that all estimates, when they differ from past performance, must err at least slightly on the side of understatement.)

The margin of safety is always dependent on the price paid.

• It will be large at one price, small at some higher price, nonexistent at some still higher price.
• If, as we suggest, the average market level of most growth stocks is too high to provide an adequate margin of safety for the buyer, then a simple technique of diversified buying in this field may not work out satisfactorily.  
• A special degree of foresight and judgment will be needed, in order that wise individual selections may overcome the hazards inherent in the customary market level of such issues as a whole.

 Ref:  The Intelligent Investor by Benjamin Graham
CHAPTER 20 “Margin of Safety” as the Central Concept of Investment





Also read:

• Margin of Safety Concept in The Business Venture of Buying and Selling Stocks
• Margin of Safety Concept in Conventional and Unconventional Investments
• Margin of Safety Concept in Speculation and Investment
• Margin of Safety Concept in Diversification
• Margin of Safety Concept in Undervalued or Bargain Stockss
• Margin of Safety Concept in Growth Stocks
• Margin of Safety in Good-Quality and Low-Quality Stocks.
• Margin of Safety Concept in Common Stocks
• Margin of Safety Concept in Bonds and Preferred Stocks

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