1 Chapter 10 Growth Stock Investing. 2 Growth Stocks Forward-Looking Analysis Portfolio Management often refers to: –“Investment Philosophy” or “style”

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Chapter 10

Growth Stock Investing

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Growth StocksForward-Looking Analysis

• Portfolio Management often refers to:– “Investment Philosophy” or “style” of stock

selection• Growth Stock Investing – investment approach that

focuses on companies expected to have above-average rates of growth in earnings and dividends (Topic of this Chapter)

• Value Investing – Investment approach that concentrates on securities considered to be temporarily undervalued or unpopular for various reasons. (Covered in Chapter 11)

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• Investors seek bargains selling at prices below their actual economic value - value determined by economic prospects– With growth stock investing – bargains are

securities selling for prices below the value of future growth opportunities

– With value investing – bargains are typically described in terms of a market price that is below the economic value of assets in place

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• Growth Stock Investors use differing criteria to identify attractive candidates for purchase:– 3 or more consecutive years of above-average

growth in both per-share earnings and revenues

– High profit margins and projected earnings increases of 10-15% (or more) for 3 to 5 yrs.

– Earnings growth at a rate that is at least twice that of the average company represented by S & P 500 Index

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– Can the company sustain rapid growth– Are there sufficient resources to finance future

growth internally or will it need to borrow funds• Ideally sufficient funds are generated from retained

earnings – Healthy balance sheets with equity at least twice debt

– Companies with heavy debt levels are avoided

– Quality of management • experience and know-how to cope with rapid growth

– Compensation plans in place to provide employee and management incentive for high-margin growth

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Growth StocksSeeking Opportunity

• Growth stock investors:– Favor aggressive companies with high P/E ratios– Dividend income is typically a secondary considerations, if

relevant at all– Willing to accept far larger than typical levels of risk in pursuit

of above-average long-term investment results– May focus first on a company’s external economic environment

• Operate in a fast-growing economic sector such as the telecommunications industry was in the recent past

– Or does the company occupy an expanding lucrative niche in a otherwise slow-growth market

• Will large and small new entrants diminish or eliminate future profit opportunities?

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Growth StocksSeeking Opportunity

• Pinpointing the source of recent and expected earnings growth is crucial– Ideally, rising sales and earnings growth should be

accompanied by higher profit margins– If accompanied by falling profit margins – negative

implications:• Higher unit sales may only be possible via expansion

– existing stores may be in saturated markets

• If sales growth is only possible via steep price cuts, future earnings growth may be constrained by market competition

• Earnings growth achieved by a one shot boost (merger, dip in tax rate) is not a sustainable activity

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Growth Stock CharacteristicsEssential Features

• 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 best companies in the best industries with the ability to sustain earnings momentum even during economic slowdowns

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• Growth Stocks:– Display high profit margins– Provide an attractive return on total assets (ROA)– Provide consistent earnings-per-share growth– Use low levels of debt financing– Lack cutthroat competition– Have superior research to develop distinctive products and new

markets– Have low overall labor costs but pay high wages to talented

employees– Have the ability to produce distinctively appealing products and

services– Are immune from regulation

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• Growth Stock Investors:– May maintain a holding for years– Sell decisions are rare (if stocks are selected

well)– Portfolio turnover rates should be minimal

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Growth Stock CharacteristicsFertile Fields for Growth

• Sustainable above-average growth indicators:– Unique product or service– High profit margins low levels of price competition

and / or superior levels of operating efficiency– Above-average ROA– Significant barriers to entry:

• Distribution economies of scale• Advertising

– build customer loyalty, brand-name awareness, and dominant market position

• Research and Development

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– Imitation prevention• Advertising

• Patents

• Copy-rights

– Market niche – market segment that can be successfully exploited through the special capabilities of a given firm

• Avon – market for in-home cosmetic sales

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• Companies in viciously competitive markets are seldom able to maintain long lasting above-normal rates of return– Basic industries where it’s tough to add value:

• Mining• Paper• Petroleum• Steel

– Easy entry and imitation:• Medical services• Restaurants• Retailing

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Growth Stock CharacteristicsConservative Financial Structure

• Growth stocks with high profit margins and high ROA are often freed from the need to raise debt or equity financing– Sales of common stock dilutes the ownership position of

current equity holders • Difficult to achieve above-average EPS growth

– Debt Financing – lenders may be inflexible during times of financial distress

• Not distracted by Financial Engineering – sophisticated manipulation of the balance sheet through use of exotic forms of debt and equity financing

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Growth Stock CharacteristicsConservative Financial Structure

• “A wonderful business is self-financing”– Microsoft

• In a wonderful business - a high degree of financial leverage reduces financial and operating decision flexibility

• In a mediocre business – financial leverage magnifies investor upside potential at the risk of magnification of downside risk– Paper, forest products, agriculture

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Pitfalls to GrowthCustomer Loyalty Risk

• Customer loyalty represents:– Future business opportunity for both

established and new products– Superior insight about special needs and price

sensitivity– Long standing business relationships built on

trust and friendships– A barrier to smaller competitors or start-ups to

stealing satisfied customers

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• Customer loyalty risk - chance of losing customers to competitors or new entrants

• When new markets are undergoing explosive growth:– Customer loyalty risk is high– Market share stability is low– Early movers may be able to achieve advantages over

subsequent competitors• However: Desktop computer early movers Atari, Digital Equip.,

and Apple gave way to Dell, Compaq, Hewlett-Packard, etc.

– Both companies and their investors are looking for answers

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• Growth simply tied to an expanding overall market is no guarantee of long-term success– New and highly capable competitors may quickly enter

the market• Snapple Beverage Company caused a stir by inventing the

“New Age” beverage industry with a range of healthful non-cola soft drinks

• Once Snapple and a host of imitators demonstrated that significant market demand existed for such products, Coke and Pepsi brought out their own offerings and crushed Snapple’s business

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Pitfalls to GrowthMerger Risk

• Creative capability that gives rise to true growth is inherent to the firm or comes from within.

• Some great growth companies that have built from within:– Wal-Mart:

• Developed a sophisticated Intranet which communicates buyer decisions to Wal-Mart’s suppliers

– Ability to meet customer needs quicker and cheaper than the competition

– Minimizes inventory and merchandising costs

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– Coco-Cola • Advertising capability• Tremendous economies of scale in distribution

– Intel and Merck• Superior research and development capabilities required to

produce an ongoing string of products and product lines

– Walt Disney Company – specializes in:• Broadcasting (ABC and ESPN)• Theme parks• Resorts• Mickey Mouse – its most precious asset

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• Most great growth companies have built from within vs. a series of mergers and acquisitions.

• Reasons:– Acquired companies often under-perform as divisions of

larger companies– Employees that flourished in the entrepreneurial

environment of a start-up or smaller co. often do not flourish in the structured atmosphere of a larger company

– Key employees often leave the acquirer to start anew• Loss of intellectual capital• May become competitors

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• Merger Risk – Economic loss stemming from failure to achieve merger benefits

• Roll-up – Company that grows through a constant acquisition binge

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• Roll up skeptics contend that when roll-up companies stop the process of constant acquisition, they often fail to deliver operating efficiencies and may drown in debt.– Waste Management, Inc.

• Hoped-for operating efficiencies failed to materialize

• The company began to strain under daunting debt

– The Loewen Group (Funeral Services Industry)• Once the pace of acquisitions tapered off, the company quickly

fell apart – corporate bankruptcy

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Pitfalls to GrowthRegulation Risk

• Regulation Risk – Chance of investor loss due to burdensome government rules and regulations– Hospital Chains– HMO’s

• Growth stock investors seek companies in industries that are not natural targets of regulation

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• Aging baby boomers will drive demand for (somewhat less regulated):– Financial Services– Leisure activities for highly educated and high

income retirees– Productivity enhancements – as the ageing

population puts a strain on the work force

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• Many aggressive growth stock investors seek out companies in the vanguard of important new innovations:– Advent of the Internet– Companies that benefit from new

communications and computer technology

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Pitfalls to GrowthPrice Risk

• Price Risk – Chance of overpaying for attractive companies

• One of the most important potential pitfalls tied to growth stock investing is that the approach seldom offers clear guidance about how much is too much to pay for a stock with attractive growth prospects

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Pitfalls to GrowthPrice Risk

– Janus Twenty Fund focused on leading-edge companies in rapidly emerging high-tech industries:

• High P/E and P/B ratios• May decline as much as 2 to 3 times the market

average of 10% during market corrections or 20% during bear markets

– Some risk-tolerant investors may ride out and even add to their positions

– Other less risk-tolerant investors may incur devastating losses

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Discounted Present ValueDPV Model

• Discounted Present Value – Current worth of future cash flows after adjusting for risk and the time value of money (actual economic value)

• Based on Expected Values – anticipated amounts• Risk-Adjusted Discount Rate (k) – or Required

Return is the interest rate required to fairly compensate investors for the risk involved with making their investment

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Discounted Present ValueDPV Model

• For an expected holding period of n years, the inherent economic value of a stock as measured by the present value of dividends over n years, and the ultimate sales price, Pn, is:

• P0 = D1 / 1+k + D2 / (1+k)2 + ... + Dn + Pn/(1 + k)n

• Here: Total Return = Dividend income plus capital appreciation

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Discounted Present ValueDPV for Dividend-Paying Stocks

• DPV Analysis:P0 = D1 / 1+k + D2 / (1+k)2 + ... + Dn + Pn/(1 + k)n

– Estimate the expected dividends and stock price performance over the period of interest

• Historical Dividend Growth Rates

• Stock Price – based on forecasted EPS and P/E ratio

– Consider the stock’s Beta (B)

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• Beta (B): a mathematical measure of the sensitivity of rates of return on a portfolio or a given stock compared with rates of return on the market as a hole– Relative risk of the stock measured in terms of stock price

volatility compared to the overall market– A high degree of such sensitivity indicates high volatility– For the overall market beta (B) = 1– Stock with a B of 1 is said to have market-like risk– If an individual stock’s beta (B) = 2, the stock is twice as risky

as the overall market (where risk is measured in terms of stock price volatility) and commands twice the overall market’s required risk premium

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• If : 5% = risk-free rate of return and

8% = risk premium

• Then: 13% = rate of return for the over all market

• If B = 2, the required rate of return is: 21%5% + (2 x 8%) = 21% = k

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• Drop estimates into formula:– P0 = D1 / 1+k + D2 / (1+k)2 + ... + Dn + Pn/(1 + k)n

• If stock price is well above P0 overpriced

• If stock price is well below P0 bargain

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Dividend Discount ModelsConstant Growth Model

• Constant Growth Model (CGM) – Stock valuation method based on constantly growing dividends and risk considerations. – Sometimes referred to as the Gordon Growth Model

after financial economist Myron J. Gordon who popularized.

• Constant Growth Model Formula:

P0 = D1 / k – g• Note: The CGM is silent on how to value non-

dividend-paying stocks.

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Dividend Discount ModelsValuation Using the CGM

• Example: Consider a stock paying a $2.40 dividend that grows by 2% per year and a required rate of return of 8%:

P0 = D1 / k – g

P0 = [ $2.40 / (.08 - .02)]

P0 = $40 • When the required rate of return is 6%:

P0 = D1 / k – g

P0 = [$2.40 / (.06 - .02)]

P0 = $60

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• The value of the Growth Stock falls with an increase in k and rises as k decreases

• An increase in the expected dividend growth rate has a valuation effect that is identical to that resulting from a decrease in the risk-adjusted discount rate:

P0 = D1 / k – g

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• Caution:– High dividend growth rates are seldom

sustainable for extended periods– When dividend growth begins to falter, high

valuations become unsustainable and growth stock prices crash.

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Growth Stock Investment StrategiesPEG: Growth at a Reasonable Price

• Investment Rule of Thumb: is a simple guide to investment valuation that has served the test of time

• Peter Lynch (legendary mutual fund investor) is famous for developing the P/E-to-Growth ratio, or PEG ratio: P/E ratio divided by the EPS growth rate– Note: Peter Lynch says that an appropriate P/E ratio

should be no higher than the EPS growth rate.– However, today’s stock market seems willing to pay

premium P/E multiples for so called “bulletproof” franchises: Microsoft.

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• The Motley Fool’s David and Tom Gardner http://www.fool.com have done a lot to popularize the use of the PEG ratio.

• If a company has a P/E of 20 and is expected to enjoy EPS growth of 20% per year, the company’s PEG ratio would be: – P/E / EPS growth rate 20 / 20 = 1

• PEG Ratio of 1 or more: the stock is considered to be fully valued

• PEG Ratio of less than 1: the stock is worthy of investment consideration

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• The PEG Ratio Rule of Thumb:• If PEG is less than or = to 1:

– may be worthy of investment attention and possible purchase

• If PEG is less than or = to .5:– definitely worthy of investment attention and may represent a

very attractive investment

• If PEG is less than or = to .33:– apt to represent an extraordinarily attractive investment

opportunity

• Therefore, the investment merit of a stock increases with a decrease in the PEG ratio

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• Growth-at-a-reasonable-price investors: Are disciplined growth stock investors who seldom buy growth stocks with PEG ratios greater than 1

• To effectively use the PEG ratio approach, investors must come up with an effective means for predicting EPS growth– Retention Rate: share of earnings retained to fund

investment

– Retention Rate: = 1 – Dividends / Net Income

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• When retained earnings are the primary source of internally generated funds for investment, the amount of internally funded growth is given by the expression:

Internally Funded Growth = Retention Rate x ROE

• Example: If a company earns a 20% rate of ROE and retains ½ of all earnings for future investment, the amount of book value growth that could be funded internally is: 10%

(=.5 x 20%)

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• Dividend Payout Ratio – is the percentage of income paid out in the form of dividends:

Dividend Payout Ratio =

Dividends / Net Income

• Therefore, a retention rate of 75% implies a payout ratio of 25% and vice versa

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Growth Stock Investment StrategiesMomentum Strategies

• Downticks – minimal decreases in stock price• Upticks – minimal increases in stock price

– Example: suppose the sale of 100 shares caused IBM to fall by .50. If the next transaction was a purchase of 2,500 shares that caused the stock to go back up .50 to the original price, then IBM’s trading activity would exhibit a new inflow of investment funds

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• Some growth stock investors favor buying stocks with net cash inflows and selling or avoiding stocks with net cash outflows– Based on a simple supply and demand view of equity

investing– New cash inflows are thought to be positive because

they suggest significant demand and emerging upward price pressure

– Net cash outflows are thought to be negative because they suggest significant supply and emerging downward price pressure

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• Money flow figures - are the dollar value of uptick trades minus downtick trades

• The Up-down ratio – reflects the value of uptick trades relative to the value of downtick trades– Relied on by day traders and short term

speculators

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• Investment professionals who use momentum-based investment strategies remain the minority on Wall Street

• Investment professionals who focus on fundamental determinants of investment value, such as earnings, book value, and dividends, are quick to point out that momentum stocks get crushed during market corrections.

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• In the long-run, EPS growth is what counts.

• However:– sustained earnings growth is difficult – even among the largest and most powerful

corporations.

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• Aggregate market capitalization growth doesn’t ensure that long-time investors prosper.– It’s common for the market value of the firm to grow

faster than stockholder rates of return

– Additional shares issued can cause rapid market value growth even for firms with slowly growing share prices

• complete mergers and acquisitions

• fund new plant and equipment

• fulfill employee stock option compensation plans

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Growth Stock Investment StrategiesTechnology Stock Investing

• Technology Stocks – Shares in companies at the vanguard of important new innovations:– Laptop computers– Portable communications devices– Cellular telephone technology– Digital cameras– Video disks– Internet

• Infrastructure building and development (Cisco Systems, Inc.)• Internet access and content (AOL)• E-commerce (Amazon.com)

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– Chemical companies• Pharmaceutical drugs• Toiletries• Cosmetics

– Biotechnology Industry• Pharmaceutical therapies• Bio-engineered products such as decease-resistant crops

– Industrial Machinery and Equipment industries• Computers• Electronic devices• Measuring instruments• Medical devices• Telecommunications• Transportation equipment

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– R & D• Computer software and services

• Technology stocks tend to do well during economic expansions (as capital spending rises)

• New innovations during the 90’s contributed to high-tech stock interest:– Microprocessors transformed the PC– With the Internet – came more powerful microprocessors.

The PC became the focus of a communications industry revolution

• A multi-capability communications device: camera, cell phone, computer, copy and fax machine, printer, telephone, TV

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• Huge potential rewards await those companies able to successfully navigate in a rapidly changing environment

• Few industry giants (IBM) have been able to stay atop their competitors, which seem to come out of nowhere:– Cicso Systems, Inc. (1984)– Microsoft Corp (1975)

• Long-term investors should consider what will happen to these stock prices, if (or when), they stumble!

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Answers to Selected End of Chapter 10 Questions

and Suggested Study

• Study the following end-of-chapter questions:

• 13. (a)• 14. (a)• 15. (c)• 19. (d)• 20. (d)

• Read the Chapter • Read the Chapter

“Summary” • Review the Power

Point Presentation

Documents

1 Chapter 10 Growth Stock Investing. 2 Growth Stocks Forward-Looking Analysis Portfolio Management often refers to: –“Investment Philosophy” or “style”