Saturday, July 14, 2007

Avoiding the Pitfalls of Growth Investing

Investing in stocks with high expected growth rates - also known as growth stocks - can be exciting; it can also be difficult and dangerous. Everyone loves to buy a company that is firing on all cylinders, growing sales and earnings at a rapid clip, and watch as the combination of improving business fundamentals (and recognition of those improving fundamentals) brings in the profits. Investors who bought into Apple (AAPL) or Google (GOOG) in 2004 and held on did very well. Examples such as these make growth investing look like a cinch – a sure ticket to easy street. And yet, that is not necessarily the case.

It pays to be aware of some of the risks that tend to afflict investors who favor fast growing companies, and to be aware of the steps that you can take to protect yourself.

There are four basic risks that growth investors face to a greater extent than other investors:

  1. The “Growth Story”: purely speculative growth or unprofitable growth
  2. If a company is growing quickly, it will be expected to keep growing quickly
  3. Growth stocks tend to suffer more in market downturns
  4. Growth stocks can become overpriced

In this column, I will discuss the first two of these risks – growth stories and elevated expectations. I will address the other risks that face growth investors in the second part of this column, to be published next week.

The “Growth Story”: purely speculative growth or unprofitable growth

The first problem with growth investing is that some stocks touted as growth stocks have no track record of strong financial growth, or have a track record of growth which is rapid, but not financially sustainable. I call this kind of company a “growth story”, by which I mean that the growth of the business is more of a story than a reality. The story may be compelling and make intuitive sense, but it is still a story, not yet a company which can be counted upon to deliver growth. There are two types of “growth stories”: purely speculative growth stories, and unprofitable growth stories.

Examples of purely speculative growth stories are seen each day by anyone with an e-mail account. Most of us are barraged daily by unsolicited “spam” messages in our inbox, touting stocks with a minimal history of creating revenues and no history of earnings, and which trade on the OTC exchanges as “pink sheet” stocks. Most of these stocks are available for a few dollars a share, and are nearly surefire ways to lose money.

Some purely speculative growth stories are listed on more reputable stock exchanges, and may have merit as speculative investments for those investors who are able to pick out the next big biotech stock while it is still a start-up. Still, even the best purely speculative growth story is a destination for money that you can afford to lose, or risk capital; not the place to find the companies that will serve as the foundation for your retirement portfolio. Investors who bought shares in eToys during the dot-com bubble and held on, hoping for the growth story to become a reality, experienced first-hand the difference between a growth story and a profitable and growing company. Despite a great story (and lots of hype about how eToys was sure to outflank its brick-and-mortar competitor, ToysRUs) eToys never turned a profit or reported great revenue growth, and shareholders were left with nothing but a sob story when eToys entered chapter 11 bankruptcy on March 7, 2001.

The second type of growth story – fast but unprofitable growth - is more dangerous, and more difficult for the average investor to recognize because it is usually accompanied not only by extensive hype in the media, but also by revenue growth. An example of a company that has grown rapidly, but not profitably, is Sirius Satellite Radio (SIRI). Like many unprofitable growth stories, Sirius financed its expansion by taking on debt and offering additional shares. Between fiscal year 2002 and 2006, sales at Sirius Satellite Radio moved from $810,000 to $637 million as it expanded its customer base, but the number of shares outstanding soared from 77 million to 1.4 billion, and total liabilities increased from $670 million to $1 billion. Yet the value of a share of SIRI moved from a closing price of $3.67 on June 7, 2002 to $3.03 as of this writing (July 2, 2007).

Shares of Sirius did experience a price spike to in the interim, closing as high as $9.01 on December 7, 2004, driven largely by the hype generated by the deal inked with Howard Stern; but unless you sold into that price spike, that didn’t do you and good. And the shares given to Howard Stern to recruit him to Sirius contributed to the dilution of existing shareholders. The point is that while SIRI was building their business, growing revenues 768 fold between 2002 and 2006, they were not building shareholder value. People who stuck with this stock underperformed the holders index funds..

Unprofitable growth stories can be avoided simply by refusing to take a major position in any company which does not report current profit in the form of earnings per share (EPS). To screen out companies without current earnings, enter the following parameter into the MoneyCentral Deluxe Stock Screener, located at

Latest Fiscal EPS >= 0

These types of “growth story” stocks are not what we are looking for – we want stocks that are growing and have been growing consistently and profitably for the last several years. We can do this by requiring reasonably high current and 5-year average ROE, ROA, and ROI, all of which measure profitability by measuring profits as returns against equity, assets, or invested capital respectively. I will go into more detail about how these rates are calculated and how to use them in a future column, but for now it is enough to know you can enter the following parameters into the Moneycentral Deluxe Stock Screener to avoid investing in an unprofitable company.

Return on Equity >= 7
ROE: 5-Year Avg. >= 8
Return on Invested Capital >= 8
ROI: 5-Year Avg. >= 8
ROA: 5-Year Avg. >= 5

We will also add another parameter to ensure that the company has grown revenue over the last 5 years at a compounded rate greater than inflation –we will use 4%:

5-Year Revenue Growth >= 4

Additionally, we will let the stock exchanges do some of the work of separating the growth stock wheat from the growth story chaff by requiring that our candidates are listed on the New York Stock Exchange, or NYSE. The NYSE has some of the most stringent listing requirements in the world, but lists enough companies to provide a wide array of opportunities. If you would prefer to focus on companies that are a part of the S&P 500, which is another very exclusive group of stocks, you can substitute the NYSE-listing parameter for the following parameter, which will narrow your field to the 500 companies that are currently components of the S&P 500 index:

Exchange = NYSE


S&P Index Membership = S&P 500

If it is growing fast, it will be expected to keep growing fast

Another problem with investing based on high expected growth rates is that companies with high, sustainable, EPS growth rates are the exception, rather than the rule. Many companies can achieve high rates of growth for a few quarters, but few can do so over longer periods of time. Picking the wrong stock, the one with the unsustainable growth rate that will revert back to more normal levels in a few quarters, can cost you dearly. If you purchase a stock with high current and recent growth rates, the expectation of future growth is usually already discounted, or incorporated into elevated analyst consensus expectations for the stock, higher than average PE ratios, or both. If other investors get the unwelcome surprise that EPS growth was below analyst expectations, they will react by dumping your stock.

The only way to address this issue is to buy stocks with low, achievable expected growth rates and PE ratios that are not much higher than average. To screen for reasonable growth expectations, we’ll require that the analyst consensus expected EPS growth for the next 5 years is less than 40%. To screen for reasonable PE ratios, we will require that our companies have a PE ratio that is less than twice the PE ratio of the average company included in the S&P 500 index:

EPS Growth Next 5 Yr <= 40
P/E Ratio: Current <= 2*S&P 500 P/E Ratio: Current

If you are using the version of this screen which searches within components of the S&P 500, you have narrowed your field from 500 companies to only 154 companies which pass this screen as of this writing. The stocks on this list include consistent, profitable growers such as computer and iPod maker Apple (AAPL), software giant Microsoft (MSFT), apparel maker Coach (COH), beverage and snack conglomerate Pepsico (PEP), latte king Starbucks (SBUX), healthcare behemoth Johnson and Johnson (JNJ), and mutual fund manager T. Rowe Price (TROW).

The NYSE version of this screen still presents more than 200 candidates, the maximum number of results that can be displayed on the deluxe screener, but many of the more speculative stocks listed on the NYSE have been removed from consideration by this screen. The refinements that I will add to this screen in the second part of this column will reduce the number of candidates from the NYSE exchange

Please check the next posting of this column, when I will go into detail about the risks of holding growth stocks during market downturns, as well as the risks of buying growth stocks at any price.

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