How to Find the Right Kind of Growth

Microsoft style growth

When I talk to people who ‘dabble’ in the stock market, one of the things that almost always comes up is growth.  The general idea seems to be that if you want a reasonable investment then put your money into Tesco, Marks & Spencer or RBS, but if you really want to get rich then the only way is to find some small company that’s about to be the Next Big Thing.

That’s great if you can get in early enough and if you’re right about that small company, but history does suggest that most private investors suck, in a big way, at spotting the Next Big Thing.  What tends to happen is that they hear about it several years too late and they hear about it at the same time as everyone else.  This means the price of that company or sector or housing market has already been bid up way too high for there to be any chance of making a decent return in the future.  What happens then is the carpet gets pulled out from under their feet and fear, emotional trauma and big losses are all the investor has for their trouble.

That’s not the sort of growth I’m talking about.

Next year’s earnings growth

What I’m also not talking about is growth in the next quarter’s earnings, or even next year’s for that matter.  I’ve done my fair share of buying and selling companies that have had a hard time this year which has enabled the canny investor to get in at a lower price.  If you do this then assumption of course is that the earnings will rebound into some ‘normal’ range in the next year or two and hey presto, you make a killing.

This is a fairly standard value investing approach and it’s where I started out back in 2007/8.  It has a lot of merits but it also involves digging around in companies that often have quite mediocre histories and fairly substantial current problems.  Some of these companies do recover as hoped and you can make quite big returns in a short time.  But it’s a pretty hairy experience.

When you’re investing in a mediocre company which has hit hard times and is implementing some kind of turnaround strategy (see my investment in YELL for an example of this) you are basically taking an educated guess that the company will be alright in the end and that Mr Market will put on his happy face at some point.

Again, this is all fine and dandy if you’re happy with investing in mediocre businesses that are taking a beating, but I want to keep stress to a minimum so that I can invest and sleep well for the next 10 or 20 years.

This means that companies which are mediocre, a bit wobbly and are having to implement some kind of turnaround strategy, they’re all no-go areas.

In fact, even when looking at nice stable companies that are doing relatively well, I’m not that interested in how the earnings will pan out next year.  As I have said before, a reasonable time frame for an investment in shares is 5 years and that goes for each individual holding as well as the portfolio as a whole.

The one thing I can be certain of is that I have no idea whatsoever what the price of any of my shares will be tomorrow, next week or next year.  It is simply impossible to know.  Even if next year’s earnings are good it often has no obvious impact on the share price.  So estimates of next year’s earnings are simply not a factor in deciding what to buy.

The growth I really like – strong, consistent, long term

In the first two articles of this series I looked at why I like a good dividend yield and why I like a company with a long stable history.  Both of these factors are driven by the idea that a share may well be held for a number of years and so predictability in the company’s earnings is important.  I want to own companies where profits are virtually certain to keep rolling in and the dividend is virtually certain to keep growing.

Give two companies, both of which have long histories with no losses and progressive dividends, which would you prefer:  the one that has grown historically at 10% a year or the one that has grown at 2% a year?

It’s not a difficult question.  All else being equal, more growth is better than less growth.  Of course, you can’t simply look at the past and project it into the future, but it has been found many times over that companies with above average growth in the past are likely to have above average growth in the future.  Not always to the same degree and not necessarily forever, but as a group they do better than the average company.

If that past growth does continue into the future and if the shares have been bought at a reasonable price (typically based on earnings and/or dividend yield) then as earnings and dividends increase the odds are that the share price will go up too.

I’ve probably used this example before, but just imagine buying a company that’s currently yielding 6%.  That’s a pretty healthy yield and if it’s sustainable then there’s a good chance that the share price will go up anyway just because that cash yield is so attractive.

But what if the company manages to grow at 10% a year, increasing the dividend progressively?  In 5 years time the dividend will have gone up by 50% and not only would you have received over 35% back on your original investment from the dividend, the shares will now be yielding 9%.  That’s a fantastic yield although it’s never likely to happen.

If the dividend is sustainable it’s far more likely that the share price will have been bid up by 50% to keep the yield nearer to the already attractive 6%.  So you’d end up with 35% gain from the dividend and another 50% from the share price increase.

Why it’s best to see growth in all the key financials

So much for all the talk about growth.  What exactly am I talking about when I say growth; do I mean growth in the CEO’s waistline?  No.  I mean growth in earnings per share, dividend per share, turnover per share, cash flow per share and net asset value per share (although in some companies like Next this figure is not so useful due to the capital structure of the business).  I’m sure there are a few other things you could lump in there.

Basically I’m looking for growth in everything.  It’s no good having lots of revenue growth if it isn’t translating into earnings, and it’s no good having earnings growth if that isn’t translating into dividends, although Warren Buffett at Berkshire Hathaway might have something different to say about that last point.  However, for most normal companies not run by the best capital allocator in the world, I would want to see dividends increasing sustainably more or less in like with earnings.

One final point is it’s no good seeing earnings and dividend increases without increases in sales since those earnings increases must be coming from increased gross margin or lower expenses or something else that is only a short term feature.  Without sales growth you cannot have sustainable earnings and dividend growth over the long term.

And the time period?  Typically I like to see this strong consistent growth in all these key metrics over at least the last 10 years.  That sort of time frame often indicates that the company has some kind of competitive advantage that allows it to either keep up in a growing industry (where there is often strong competition) or to expand market share in a static or even declining industry.  Either way, it’s a useful indicator as to whether a company is above average or not.

There are some tools, free and paid, which give nicely laid out tables of financial data going back over 10 years.  I’ll go over these at some later point but off the top of my head there is Sharelockholmes, Digital Look, Morningstar Premium, ShareScope, Investor Chronicle and probably many others.

Buy only at the best possible price

I was going to say ‘only at a reasonable price’, which is the mantra of GARP (Growth At a Reasonable Price) investors, but that’s not what I mean.  GARP is more focussed on growth.  It’s growth first and then a reasonable price second.  As a value investor what I’m after is a fantastic price first and then as much growth as I can get for that price second.

Price, as always, is the key part to success in investing.  As I mentioned recently, Vodafone has a great track record of growth, but the shareholders have seen almost nothing but losses from the turn of the century.  That’s because they were paying a huge price on the hope that Vodafone would grow quickly and the share price would follow.  Vodafone has grown quickly but if you’re paying 50 times earnings and 100 times the dividend, there’s nothing to stop the share price from halving, no matter how good the growth.  In Vodafone’s case it’s taken 10 years for the share price and the company’s earnings and dividends to come together and create an attractive investment.

Author: John Kingham

I cover both the theory and practice of investing in high-quality UK dividend stocks for long-term income and growth.

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