There is no cut and dried formula to becoming a successful growth investor. If you are the one who likes new stories, new dreams, new opportunities, then you can think of giving it a try.
Growth investing needs a risk-taking appetite as it involves taking the bull by its horns. Chances are you would fall once or twice before getting it right. But one right move ca n give you profits of a lifetime. It’s all like producing fire by striking stones. You know it’s risky and takes its own time but one successful attempt and you are way ahead of the risk-averse crowd.
Johnny: You seem to be saying that if you are not a growth investor then you are missing something. But I can better appreciate your point if you first explain what growth investing means.
Jinny: Growth investing is a type of investment strategy in which an investor makes investments in firms that have good growth potential.
Growth investors are always sniffing for new growth opportunities. It could be an opportunity in a totally new emerging industry or a sector, or it could be in a new company in a well-established industry. The bottom line is that earnings of growth companies are expected to grow at an above-average rate compared with other firms in the same industry or the overall market. Growth rates of different companies could vary, but a typical growth candidate generally grows at rates of 20%, 30% and 40%, or even higher.
There are always strong firms in a weak industry and weak firms in a strong industry. Growth investors try to separate the chaff from the grain. Their focus is more on firms showing early signs of success. That’s why growth investors do not focus much on well-established firms paying fat dividends. Growth investors like a firm that is more likely to redeploy its earnings for fuelling future growth. Their aim is to get maximum capital appreciation on their investments. The higher the better, seems like a wish in the heart of every investor. But before you decide to play the game of growth investment yourself, you must keep in mind that you may need to run on slippery ground.
Illustration: Jayachandran / Mint
Johnny: Runners beware! But can you elaborate why the ground is slippery? I mean, what kind of risks and rewards are there in growth investing?
Jinny: The risks and rewards of growth investing are two sides of the same coin. As already said, the focus in growth investing is always on the future earning potential of a company. Everything else, including the current market price of stocks, takes a back seat. The price-earnings (P-E) multiple of a growth stock may go into a high range. As you know, the P-E multiple is often used to determine the worth of a company’s stocks. For instance, a P-E multiple of 40 means that for every rupee of earnings per share, you are paying Rs40 as stock price.
Growth stocks might sell at a valuation far in excess of the inherent worth of the company in the belief that the current stock price would always rise, as long as the company is meeting its earnings target. When a company is growing at a higher rate, the whole always seems bigger than the sum total of individual parts. However, at the peak of growth investing, there is no margin of safety. There is no formula that could tell us about the ultimate growth potential of a company with absolute certainty. Investors have to use their own judgement. The moment a company falters, its stock price tumbles.
Johnny: A risky game it seems. We really need to follow some safety rules. What do you say?
Jinny: Well, there is already one rule of safety. It is called growth at a reasonable price (Garp), made famous by the legendary investor Peter Lynch. Growth investors could use this rule to keep their euphoria under control. Garp uses what is called a price/earnings to growth (PEG) ratio. It is derived by dividing the P-E multiple with the rate of earnings growth. So a company with a P-E multiple of 20 and earnings growth rate of 40% would have a PEG ratio of 0.5.
A quick rule of thumb is that a growth stock having a PEG ratio of 1 or less than 1 is still in safe territory in terms of valuations. In other words, the rate of growth must remain higher or at least equal to the P-E multiple to keep a growth stock at a reasonable price. Things start getting out of control when a company with an earnings growth rate of, say, 20% starts selling at a P-E multiple of, say, 40. Although the wisdom of the PEG rule can’t be proved with mathematical precision, it really sounds sensible.
When you are standing on a cliff, it is always better to draw a line of safety. The PEG ratio, in a way, helps us in drawing our own line. It is another matter that many times we knowingly cross it.
Jinny: That’s true. Growth euphoria sometimes makes us blind.
What: Growth investment is a type of investment strategy in which an investor puts money in firms having good growth potential.
How: Growth investors focus on companies growing at an above-average rate compared with other firms in the same industry or the overall market.
Why: Growth investors focus on earnings growth rate because a higher growth rate leads to higher stock price.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at firstname.lastname@example.org