Monday, February 4, 2008

Their Stumble, Your Opportunity: Investing in Growth Stocks When They Stumble

Some call it a bear market. Some call it a 'correction'. Regardless of what you call it; periods of dropping stock prices, such as the one that we are experiencing right now, mean pain for investors. If you did your homework and stuck to shares of great businesses selling at great prices, then you're probably experiencing less pain than other investors; but you are still feeling the hurt.

But you are not alone in your pain, and you don't have to miss the opportunities offered by the current market malaise. Companies that are transitioning from one phase of their development to the next are being punished unfairly by the market right now, and that means that some great businesses are not just on sale, they are in the bargin-bin.

The Not-So-Secret Lives of Companies

Like people, companies go through different phases in their lives. They experience childhood as startups, they go through growth-spurts as smaller fast-growing companies, and if they survive the rigors of competition and the recklessness of youth, they become stable (if somewhat boring) pillars of society that advance their goals in a fairly predictable fashion.

Most of us have the benefit of having the awkward transitions between the phases of our lives occur mostly in private (unless we have the misfortune of being famous as children); but publicly-traded companies experience these awkward moments in the full glare of the spotlight. And just as everyone cringes when they hear a teenager's voice crack during the middle of a choir perforance; so everyone dumps the shares in a great company when it enters an awkward transitional period. And when the economy is slowing down, many companies go through awkward transitional periods.

Why They Get Dumped

Stock prices are based on expectations for future earnings, and when those expectations change, stock prices tend to move very quickly and to over-react to those changed expectations. When a company announces that it will grow earnings at only 20 percent over the next two years (or when analysts deduce and report as much), a company that has been growing earnings at 23% each year will drop a bit. However, a company that has been growing earnings at 30 percent per year which announces that it will only grow earnings at 20 percent per year will drop like a rock. The share price might go lower than it ever would have if the company had simply maintained a 20 percent growth rate the whole time.

There are quite a few reasons why the stock market over-reacts to dissapointments, but the most important one has to do with the very short timeframes on which most money managers have their performance evaluated. If your bonus and your job is riding on the performance of a portfolio over a 12-month span of time (as is true of mutual fund and hedge fund managers) then you don't care that a stock which just announced a slowdown in earnings is still a good value. You will sell so that you don't end up holding a stock that is in the dumps and blowing your annual bonus. Because professional money-managers dominate trading, and few are willing to buy a company trading at a value which might take years to appreciate in price, drops in earnings forecasts can put stocks on the chopping block.

And when money-managers smell a recession on the horizon, they dump consumer descretionary stocks (which is to say, stocks in companies that make things that people don't really need) indescriminately.

Two Great Companies to Buy Now

Starbucks (SBUX): Sure, the king of coffee is facing a consumer slowdown, rising milk prices which cut into margins, and competition from McDonalds. But, according to statements that Howard Schultz made in a recent interview in Fortune magazine, Starbucks sells less than 10% of the coffee consumed in the US, and less than 1% of the coffee consumed outside of the US. This leaves a lot of room for growth, undercutting analyst argumens that the market for this company's products is saturated. Now Schultz, the CEO who drove the company for most of its formative years, has resumed the helm of the coffee giant to address the recent drop in Starbucks shares. These shares are at multi-year lows, presenting a great opportunity for patient investors to buy a great business at a great price.

Coach (COH): This maker of high-end handbags is the poster child for unnecessary spending - after all, a $500 handbag makes a $5 latte look like a bargain. But, despite the slowdown in consumer spending, Coach's latest earnings report showed earnings growing over the last year by 16%, beating analyst estimates yet again. And the shares were recently selling at a price to earnings ratio of only 16 - the cheapest price since this company went public. On a recent visit to Bellevue Square mall, I noticed that the Coach store was packed. This is a great company, selling at an unusually low price.

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