In our quest to understand why we invest in a particular share and what type of return we can expect from it, we have looked at steady growers, income-producing shares and troubled shares.
This week, we look at investing in growth stocks, starting with the broader picture - namely, the origins and nature of superior earnings growth.
The simplest definition of a growth company is one that consistently grows its earnings faster than the rest of the market. However, I would like to talk about the purest, truest nature of growth stocks.
As an economy develops and expands, growth can usually be ascribed to three major processes. The first is population growth, the second is the accumulation of capital (wealth creation) and the third is technological progress. While businesses cannot influence population growth, the creation of capital and the invention of new technologies are firmly within their power. True growth comes from within a company.
This brings me to the well-intended but somewhat misleading classification of funds and managers who invest in cyclical resources shares as growth investors.
My point here is not to address this complicated matter, with which the entire industry has grappled for some time, but rather to caution you, the investor, that resources shares can at best provide sporadic bursts of growth. However exciting the returns from these types of shares when they happen, they are not true examples of growth stock investing.
Companies in the resources sector can innovate and develop exciting new products (Sasol is a case in point), but the bulk of their business is not going to qualify as growth business. They will remain highly dependent on the commodity cycle.
I think managers and funds that invest in cyclical and resources shares could be renamed growth phase investors, because they tend to buy into phases of growth and not necessarily into growth companies. The distinction is important because the guidelines and time horizon for investing in true growth companies are entirely different from those for resources and cyclical shares.
The illusion of a true growth com-pany can be created under the following two circumstances:
- Companies growing their turnover and earnings by acquiring other companies. Many information technology (IT) shares, and even a few industrial shares of the past decade, fall into this category. They may appear to be getting bigger and growing faster than the rest of the market, but unless they change their nature, they will eventually revert to producing average growth.
For example, a company making plain cardboard boxes may acquire a specialist packaging company with ground-breaking technology. It may then start operating in an area where it can add more value, constantly innovate and show a better product margin, such as cosmetics, where the appeal of packaging helps sales.
But growing by acquisition is not necessarily sustainable or genuine.
- A company is in a growth industry or serves a growth industry. A good example of this is companies that supply the IT industry with basic screens, routers, casings and so on. It is the innovators of products and software that can rightfully call themselves growth companies, while their suppliers, once the components have been commoditised, remain under constant price pressure from their customers.
In general, growth companies are ones that create their own markets, providing products that are distinctive in the eyes of the market, even for a brief period while their competitors get their ducks in a row.
Apple is a good example of such a company. Various versions of the iPod accounted for 92.1 percent of the fast-growing market for hard drive-based music players (MP3 players) as at last September. Apple's share price, after yielding very little in 2001 and 2002, shot up from US$15 (R95) two years ago to the current price of US$42.50 (R270). Who really needs an MP3 player that can store 10 000 songs when portable CD players and Minidisc players do a fine job? When they weren't around, the question seemed fair. Now it seems downright silly. Growth stock investing can be very exciting!
True growth companies are rare. Even the best ones go through good and bad phases, as high growth strategies do not come without risk.
There are, however, many growth shares in which you can invest, regardless of whether or not the company qualifies as a growth company according to the purists.
My next column will focus on the guidelines for investing in shares that are expected to grow their profits faster than others.