25th Feb '22 by Ben Hobson

4 comments 4782 reads

Companies with the potential to grow quickly are like a magnet to investors in the stock market. And while they can suffer in volatile conditions, they’re still the source of some of the most inspiring investment success stories you’ll ever hear. At their best, they can have a transforming impact not just on their shareholders but also their staff, customers and even entire industries.

But while growth companies can be appealing, they can also come with hefty price tags. In buoyant economic conditions and periods when investors feel confident, growth shares can become, relatively, very expensive. But that’s not always a bad thing…

Paying what looks like a high price for a share - which is typically measured by the price-to-earnings ratio (P/E) - may be justified if a company is growing quickly. When a firm consistently beats earnings forecasts, the market can find itself in perpetual catch-up mode. And that makes valuing it quite tricky.

As the share price leaps along behind the rapid clip of earnings growth - and as more investors buy into the story - the momentum can be very powerful. For growth investors who are relaxed about high valuations, this momentum is exactly what they are after. But there can be problems…

The catch is that if and when momentum begins to weaken, the performance can plummet. Given that many growth companies tend to be smaller in size, they can be particularly vulnerable and unpredictable. So when things go wrong, valuations can tumble heavily.

Another risk with growth stocks is a change in the economic outlook. A deteriorating backdrop can quickly scare investors out of more speculative shares. Inflation can also be a drag. That’s because the valuations of growth stocks are often based on their future cashflows. If the value of those cashflows comes under pressure from rising inflation, then the multiples that investors are prepared to pay for them today will also come down.

With these kinds of risks in mind, one way of finding the next potential stars of the stock market is a strategy that focuses on growth - but without overpaying for it. It’s called ‘growth at a reasonable price’ and one of the keys to the approach is a metric called the PEG...

Walking the tightrope of growth and value

One of the early industry advocates for buying growth stocks at reasonable prices was an investor called…

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uncle265

25th Feb '22

Excellent article and most informative. Thank you.

ijh9547

27th Feb '22

Thanks Ben,, very interesting

Doug2b

28th Feb '22

This is interesting. Worth bearing in mnd that when Peter Lynch was a fund manager c1977 to c1990, inflation was higher, quite a lot of so called growth was just price inflation, hence finding a stock with an annual earnings growth rate of 10% and a PE ratio of 10, means something very different in the higher inflation environment. The equivalent in a very low inflation environment might be, say, a PE ratio of 10 and a growth rate of perhaps around 6% pa.

Lynch would look for high growth businesses in non-growth or low growth industries. The reason for this is that growing and highly successful businesses in low growth sectors tended to be overlooked and the sector would draw in less competition. High growth sectors tending to attract a larger number of new competitors.

The time period during which Lynch invested, c77 to c90, was the perfect time for the value growth investor, with hindsight at least, the markets were still very jittery in 77 following the oil price shocks and the market collapse from c3 years earlier. During other periods, value growth investors have had to sit through extended periods when their high quality under valued holdings were ignored by the market for years on end. John Neff in his investing biography covers this extensively, the hot stock era of the 1960s was intsensely frustrating at times for Neff when the whole US market seemed obsessed with what Jerry Tsai might be buying.

Just one other point. Declared earnings can be a useful indicator, but I only treat them as indicative, often so called retained earnings never make it to the balance sheet equity line in full and can often be diluted down by share issuing. Hence my valuations are always equity growth based rather than earnings based.

But, take ScS for example. Typical Lynch stock, i.e. high growth in a low growth sector. ScS does appear to have transformed itself during Covid. Major investment in their on line offering, along with other changes, appears to have greatly improved the business in terms of turnover and profitability.

Here is the 'But'. Although in year ending to July 21, ScS generated tangible equity growth of over 30% of its current MCap - this is the kind of ratio normally only seen in 1932, 1974 and 2008, makes you want to check that you have not put the decimal in the wrong place, a 'real' PE of c3. There was a one off sector post lockdown bounce back in 21 and year ending July 22 will also be impacted by supply chain hold ups. So for the year end to July 22, ScS will likely only see its net tangible equity grow by an amount equivalent to c15% to 20% of its current MCap - I say only!

But, according to a PEG ratio this is not growth is it because 2022 earnings will almost certainly be lower than 2021 earnings. And yet, the net tangible equity for ScS at the end of 2022 will likely be 15% to 20% higher at the end of July 2022 and the tangible equity will have grown by over 50% as a % of MCap over the 2 year period - i.e. tangible shareholder wealth within the business having been increased by c50% of their investment, based upon the current share price.

So what is real growth, should one be tied to year on year earnings growth, or is the continuing build up in tangible equity, i.e. the real wealth created by the business, the growth that really matters?

How to find growth stocks at attractive prices

Walking the tightrope of growth and value

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Ben Hobson

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