Investing for growth sounds like stating the obvious – the only reason for saving, after all, is so that our money will grow. But growth also refers to a particular style of stock market investing which picks companies that are likely to grow rapidly.
Growth investors will usually have more small companies and businesses in new and emerging industries, like wind power generation or silicon chip production, rather than large well-established businesses, like retailers or food companies. But that is not a hard and fast rule: the mining industry has been one of the fastest-growing industries in recent years; and, as many investors know to their cost, technology, supposedly the archetypal growth industry has spent much of this decade shrinking and retrenching.
So how do you spot a growth company? Andrew Beal, who runs the Henderson TR Pacific Investment Trust, says the key is that a company’s growth should deliver long-term value. That sounds obvious but spotting it is not straightforward. He looks for companies whose profits consistently beat expectations and where analysts are regularly upgrading their forecasts. Then he uses a rigorous, three-stage analysis to assess whether that growth will continue.
First, he produces explicit three-year forecasts for the company; next, he looks at the expected cash flow over the medium-term; and finally he assesses how the company will look after that, in say 10 or 15 years time. By then, he believes, competitors will have eroded whatever edge the business has and its returns are likely to fall into line with the economy generally. If the forecasts do not indicate that, he will be suspicious. What business, he asks, can hope to maintain a competitive edge for 20 years or more?
He believes that investors can be too short-term, focusing on the next year or two’s earnings rather than looking at the longer-term prospects. Growth investors, on the other hand, have to be more patient.
Many growth companies will look expensive based on the sales and profits they are likely to generate in the next year or two. But, says Beal, you also need to look to the next stage and consider the dynamics of the industry it operates in and the potential for its products and services.
The favourite example cited by growth investors is Microsoft. Back in 1990, it may have looked expensive but, says Beal; it was worth buying it even valued at 40 times its total sales – despite the fact that companies are usually valued on multiples of their profits rather than their sales. ‘If you had, you would have got a return of 15 per cent a year for the next 15 years.’
Microsoft is an extreme example although there are other businesses which have grown rapidly enough to justify what looked like extremely high valuations. Search engine Google, which has grown its revenues more than seven-fold in the last three years, may be one of them although much depends on its retaining its lead over rivals like Yahoo and Microsoft and continuing to come up with new sources of revenue.
Beal says there are plenty of other growth companies to choose from, particularly in the Asian markets his investment trust specialises in.
Many of the economies in the region are enjoying rapid growth – China and India are the most obvious examples – and the increasingly wealthy population are starting to demand the telephones, cars and other consumer goods which are taken for granted in more developed countries. Businesses which can tap into that demand should have the potential for rapid growth.
Traditionally, growth companies have not paid dividends: some start-ups and rapidly growing companies will have high borrowings and be making losses so would simply be unable to afford them; while even those which have strong enough cash flow to afford them often prefer to reinvest the cash in growing the businesses.
But some investors do now think that dividends are a good discipline, even among growth companies, for those that can afford them. Even Microsoft has now started paying dividends and, says Beal, such payments can signal both that the company recognises the need to look after its shareholders as well as a healthy sign that its profits are being turned into real hard cash.
There are more growth businesses among small companies than large, if only because simple arithmetic dictates that it is easier to double sales when they you are starting at £1 million than £10 billion. But small companies are also more likely to find the new products, services and other niches with the potential to become large, established markets in five or ten years time.
Likewise, some sectors have more growth companies than others: the real estate sector, for example, is valued at less than 8 times earnings, reflecting the fact that its earnings are not expected to grow rapidly while technology hardware companies stand at almost 40 times earnings reflecting their better growth prospects.
Investing in small companies can be riskier than buying established businesses. Their management systems may be less well-developed and the promising product or service may not live up to expectations. The most extreme example of that was the dot.com bubble in the late 1990s.
Then, investors were scrambling to tap into the huge growth potential they saw in the internet and virtually any company with ambitions to offer an internet service or with some innovative technology to help us use it were in great demand. Businesses which were little more than a bright idea commanded high valuations despite the fact that sales, never mind profits, were often years away. Internet stocks were valued on the basis of eyeballs or clicks – the number of people who visited their sites – rather than the amount of revenue actually generated by their visits. That would be like valuing Marks & Spencer on the basis of how many people walk through its stores each day.
Unsurprisingly, all this euphoria evaporated quickly and painfully. Some of the most-hyped businesses, such as boo.com which was once valued at £200 million but which simply failed to create the promised internet fashion retailer, simply disappeared. Others, like travel business lastminute.com and auction site Qxl, still exist but are worth far less than they were in those heady days.
But even well-established companies, and normally shrewd investors, can get carried away by growth euphoria. Marconi, which emerged from the ultra-conservative – and heavily value-oriented – General Electric Company made a string of acquisitions of wireless and other telecoms companies, winning itself plaudits from investors and a high valuation. Unfortunately, however, many of the businesses it acquired turned out to be worth little, it failed to win the contracts it hoped for, while fierce competition forced down the price of the services it was offering. It was forced to renegotiate the sizable borrowings resulting from its acquisition spree, leaving its bankers owning the majority of the company. Most of the business has now been sold to rival Ericsson.
More recently, iSoft, which was expected to enjoy healthy growth from its contracts to upgrade National Health Service computers, saw its shares slump because of delays in the upgrade programme and changes to its accounting policies reduced its reported profits.
Of course, all investors can make mistakes. But such disasters underline the importance of doing a reality check before buying a growth company: are the forecasts on which the valuation is based realistic? Will the market really grow as rapidly as expected? And what share of it can the particular company expect to take?
Beal believes that it is possible to find good growth companies, whatever the state of the economy. He points to commodity and energy companies where, he says: ‘it became clear in 2001 to 2002 that these companies were seeing consistent and sustained earnings upgrades. The market had failed to understand and appreciate their growth prospects. Commodities had traditionally been seen as value stocks but they fitted the into a growth portfolio.’
And he thinks that both small and large companies can provide growth opportunities. ‘We are not specifically looking for small company ideas, although we do tend to be short of mega-cap companies and have a concentration in the mid-cap domain.’
The problem for investors is that growth does not continue forever and investors have to be alert both to trends within a particular industry, and events at an individual company. Take pharmaceuticals: for years, it was rated as a growth industry, producing an ever-increasing stream of profits spurred by new product development and clever marketing to the medical profession. Now, however, new drugs are harder to find and more expensive to bring to market while governments around the world are pushing for lower prices. Growth is slowing to such an extent that drug companies are now appearing in value investors’ portfolios.
Telecoms are another example. Back in the 1990s, mobile phone companies like Vodafone attracted very high ratings from investors excited by the prospect of 3G telephones which would allow us to watch films and listen to music on our handsets. Now that these telephones are actually here, however, it is clear that they are less popular, and costing far more to promote than expected and telecoms companies are now treated more like utilities, ranked on the basis of their cash flow and dividend payments, rather than their growth potential.
Identifying the end of a growth cycle is just as important a skill as identifying the growing businesses. Among the clues are that the company’s profits no longer consistently beats expectations or the value of its shares has risen to such an extent that its superior growth prospects are already fully appreciated by other investors. Setting a target for the company’s shares, and selling when it gets there, is also an important discipline, says Beal.
‘What is necessary for both growth and value investors is a disciplined approach,’ he adds. ‘That will work well whatever the market.’
Many fund managers, and their funds, will have a bias towards a growth style of investing. Among the investment trusts managed by Henderson Global Investors, Henderson Smaller Companies, Henderson Strata, Henderson EuroTrust, TR European Growth Trust as well as Beal’s Henderson TR Pacific would all come within the growth stable.
The type which suits individual investors will depend on factors like age, the amount of risk they are willing to take and the types of other investment in their portfolio.