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Fertile Fields
“Most analysts feel they must choose between two approaches customarily thought to be in opposition: ‘value’ and ‘growth.’ Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing. We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.” —Warren Buffett (1992 Letter to Shareholders)
Stock markets had a positive week to close out the month of August and welcome in September. The S&P 500 was up about 2.5% for the week, while the Nasdaq rose about 3.3%.
So far in 2023, the S&P 500 is now up over 18% on the year, and the Nasdaq is up over 41%.
Given the return of growth stocks this year, we got to thinking about what makes a good growth stock versus a bad one. Many so-called growth companies from 2020 and 2021 were not growth stocks at all and remain down 50% or more from their previous highs. On the other hand, some that had fallen in 2022 have reached or approached all-time highs in 2023.
For insight, we first turn to T. Rowe Price—the person and growth investor, not the company he founded. In John Train’s book The Money Masters, first published in 1980, he detailed some of Price’s philosophy:
Price’s thesis, briefly, is that the investor’s best hope of doing well is by seeking the fertile fields for growth, and then holding growth stocks for long periods of time. He defines a growth company as one with “long-term growth of earnings, reaching a new high level per share at the peak of each succeeding major business cycle and which gives indications of reaching new high earnings at the peak of future business cycles.” It may, however, have declining earnings within a business cycle.
Price adds that since industries and corporations both have life cycles, the most profitable and least risky time to own a share is during the early stages of growth. After a company reaches maturity, the investor's opportunity falls and his risk rises.
How does one find a growth company and industry? Train continued with a few insights from Price:
Price maintains that there are two aspects of capitalizing on the “fertile fields for growth”: identifying an industry that is still enjoying its growth phase, and settling on the most promising company or companies within that industry.
The two best indicators of a growth industry are unit volume of sales (not dollar volume) and net earnings. Return on investment must also be watched carefully. To be attractive, an industry should be improving in both unit volume and net earnings.
This also reminded us of further wisdom from the past via Thomas Phelps, author of the book 100 to 1 in the Stock Market, which was first published in 1972. After studying stocks that had returned one hundredfold, Phelps distilled the major winners into four categories.
The four categories I see are these:
Advance primarily due to recovery from extremely depressed prices at bottom of greatest bear market in American history. Special panic or distress situations at other times belong in this group too.
Advance primarily due to change in supply-demand ratio for a basic commodity, reflected in a sharply higher commodity price.
Advance primarily due to great leverage in capital structure in long periods of expanding business and inflation.
Advance primarily due to the arithmetical result of re-investing earnings at substantially higher than average rates of return on invested capital.
And to end with a final piece of advice in one’s search for the big winners and potential growth companies, let’s remember that price does matter. As Terry Smith, a growth investor of today, describes it in his book Investing for Growth:
Only buy investments that you really want to own and at a price at which you are happy to own them. If you buy shares – or any other investment – with the sole intention of on-selling them, or if you overpay even for good companies, you are engaging in “greater fool theory”. The success of that strategy depends upon someone else being willing to play the same game.
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