Growth Investing

We've already got a grip on what Value Investing is all about. If you read our piece on Value, you'll remember that its mostly about patience.

On the other hand, the Growth School bets the farm on the Future.

Growth investing, as defined by Mr Thomas Rowe Price, a pioneer of this approach in the late 1930s, is:

Growth stock investing focuses on well-managed companies whose earnings and dividends are expected to grow faster than both inflation and the overall economy. The real test for a growth company is its ability to sustain earnings momentum even during economic slowdowns. Such companies will provide long-term growth of capital, preserving the investor's purchasing power against erosion from rising prices.

Ok, that's simple enough. This is of course the 'In' school for the past few years. Growth investing has been trouncing value-based investing for the past few years by a wide margin. While we have little data for the Indian market, there is a wealth of it on such issues about the US market. And if you look at the chart below it is amply clear that Growth has been the way to go for the past few years.

The basic assumption underlying growth stock investing is that these companies have above average rate of earnings growth and that over time their stock prices will reflect this growth. The difference between growth and value investing is best understood by the following question.

 

Would you rather buy a great company at a good price or a good company at a great price?

Growth investing places great store in buying great companies at a good price. Not necessarily at a great price.

The metrics of growth investing are very different from that of value investing. They do not place great emphasis on tools such as P/E, P/B, dividend yield or Replacement value. Growth investors tend to look more at the future. So they are more concerned with prospective P/E's and PEG ratios. In other words they are more concerned with the company's P/E based on 2004 earnings than with 2000 earnings.

Since they place great store by Intangibles such as brand value, technology edge et al, they typically disregard measures such as Replacement value and Book value. Measures such as Replacement value and Book value are based on accounting entries in the Balance sheet and do not therefore capture the intangible assets of the company. The intangibles could be the company's brands, its human capital or its IPRs.

Also, since they are typically on the lookout for high growth businesses, they disregard dividend yields. Not without reason - fast growing companies justifiably prefer to reinvest their profits in their business rather than pay them out.

Irrespective of whether you are growth or value investor, Management is always a key attribute in buying a stock. But with a growth company, where the job is not just to maintain consistent but higher than average growth rates, the nature of the challenge faced by management is of a higher order. Without any prejudice to the Value school, it is fair to presume that the premium placed on management quality by Growth investing is definitely in another league altogether.

The same applies to interest rates as well. Typically Growth stocks are more sensitive to interest. This has more to do with the growth premium than with debt levels.

 

Growth premium?

Given their steady but above average growth rates, growth companies obviously get more attractive during the period when interest rates are low or are headed lower. However when interest rates head higher, then the value of the future cash flows gets impacted quite substantially and the appeal of growth companies does suffer as a consequence.

Also, remember that Growth stocks get a lot of their value from future cash flows. Typically, the impact of future cash flows in a stock's current valuation is much higher than that for a value stock. But when interest rates rise, the value of those future cash flows drops very rapidly, hence making the stock more vulnerable to interest rates.

The key issues that a growth company faces are

1. Can it sustain its rapid pace of growth?
2. Can growth be financed internally or does it require borrowing money?
3. Is the company growing faster than it its peer group? (This is particularly important because in a favourable business environment a lot of companies will record high growth rates. The key is to identify whether this growth is an industry wide phenomenon or whether the said company has a key advantage that is propelling it at a higher growth rate than the peer group. And whether that advantage is sustainable.)
4. Does the management have the ability to manage this growth?

The question of how to value growth stocks is one that has no straightforward or simple answers. Unlike Value investing which is quite well defined and has easy to understand metrics, growth investing is more difficult to quantify. Discounted Cash Flow (DCF or NPV) is the only tool that an Investor trying to evaluate growth companies can turn to.

The catch is that DCF involves several assumptions :

• the rate at which cash flows will grow, the period of the explicit forecast (for which cash flows have been estimated),
• the interest rate to be used to discount the future cash flows (because money to be received tomorrow has a lower value today )
• an estimate of terminal value (the value at which one expects the stock to trade at the end of the explicit forecast period).

The DCF model has its roots in what is called the Dividend Discount model. It owes its origin to John Burr Williams who introduced this model in his Theory of Investment value in 1938. In his words,

"In short a stock is worth only what you can get out of it. Even so spoke the old farmer to his son:
A cow for her milk
A Hen for her eggs
A stock, by heck
For her dividends"

This is obviously no easy task, because it involves complex calculations and many assumptions. But this remains the only way to value growth stock. It is because it involves so many assumptions about the future that growth investing stands apart from value investing.

And because Growth investing is less about a rule-bound approach, it is quite easy to err. Growth stock investors would do well to remember this warning from Warren Buffett in his 1989 Chairman's speech

"In a finite world, high growth rates must self-destruct. If the base from which the growth is taking place is tiny, this law may not operate for a time. But when the base balloons, the party ends. A high growth rate eventually forges its own anchor.

Carl Sagan has entertainingly described this phenomenon, musing about the destiny of bacteria that reproduce by dividing into two every 15 minutes. Says Sagan: "That means four doublings an hour, and 96 doublings a day. Although a bacterium weighs only about a trillionth of a gram, its descendants, after a day of wild asexual abandon, will collectively weigh as much as a mountain...in two days, more than the sun - and before very long, everything in the universe will be made of bacteria."

Not to worry, says Sagan. Some obstacle always impedes this kind of exponential growth. "The bugs run out of food, or they poison each other, or they are shy about reproducing in public."

 

So which is the better way to make money? Growth or Value investing?

As history shows there have been many investors from both schools who have met with great success. The key to their success has been their discipline and commitment to following what they understood best.

Investors who play musical chairs between these 2 styles run a greater risk. The risk of following the wrong strategy at the wrong point!