Are growth stocks for you?

Growth stocks have become increasingly popular as they have trounced value stocks since the global financial crisis. They’re not restricted to a particular industry, although you’re more likely to find them in industries like technology. A growth share is a company that investors have high expectations for growth in the future. That means that investors are willing to pay higher valuations. The hope of growth investors is that although a share may be more expensive on a relative basis, strong growth will more than make up for higher valuations.

The key to evaluating growth stocks is to focus on investor expectations. Nobody has a crystal ball. Valuing any share is reliant on projecting growth into the future. It is an exercise in conviction in the prospects of the company.

Nvidia NVDA is a good example. They’ve made almost psychic like investments in GPUs, networking semis, and software, as the company spent the past decade (if not longer) laying the groundwork to emerge as the clear leader in AI training GPUs and associated software and tools. Like many chipmakers, Nvidia’s hefty R&D budget enabled the company to remain on the cutting edge of GPU design – we’ll speak more about capital allocation further in this article. Investors that believed in this story and had conviction in Nvidia’s ability to deliver were handsomely rewarded.

However, there are many variables that can change the trajectory of a company, especially over such a long-time horizon. Poor economic conditions, poor capital allocation, changing consumer tastes and preferences, increased competition – the list is endless. If expectations get too high and are not met share prices generally head south. It is more often than not that high expectations do not eventuate. Graham Hand has written on how 2.4% of companies deliver all shareholder net wealth.

How expectations can go wrong

We can turn to history for an example of how expectations can get out of control. The Nifty Fifty crazeled to disastrous outcomes for many investors.

The Nifty Fifty was the name given to a group of US growth stocks which surged in the 1960s and early 1970s, becoming symbolic of the bull market. The companies included household names like McDonald’s, Coca-Cola, Pepsi, Johnson and Johnson and Pfizer. They traded on very high valuations over many years. Their product lines range from drugs, computers and electronics to photography, food, tobacco and retailing. Notably absent were the cyclical industries: auto, steel, transportation, capital goods, and oil.

These were all very strong companies. They were growing quickly and had strong balance sheets. As the bull market continued, they became known as one decision stocks – meaning that they could be purchased at any price and never sold. Expectations soared for these stocks. Markets continued to climb along with valuation levels. Yet investors ignored high valuations because markets kept going up.

By the end of 1972, the average PE of the Nifty Fifty stocks was 41.9. This was more than double that of the S&P 500 which had a PE of 18.9. Over one-fifth of these firms sported price-to-earnings ratios in excess of 50, and Polaroid was selling at over 90 times earnings.
By the early 70s as markets continued to rise more investors got into the game. It was easy for investors to get involved through managed (or mutual) funds. From 1960 to 1965, assets of funds doubled. From 1965 to 1970 they doubled again, peaking in 1972. By the end of the 1960s, there were seven times as many Americans that held shares than during the height of the 1929 bubble.

At the beginning of 1973, conditions started to turn. Inflation started climbing and eye watering budget deficits swollen by the Vietnam War needed financing. The market reacted poorly and headed south. 1973 and 1974 saw the worst downturn since the Great Depression. The S&P 500 dove 42%. It took almost 6 tears for a full recovery. This effected all global markets – some much more severely than the US. For instance, the UK market didn’t recover for over 13 years.

This was a prime example of sky-high expectations combined with sky high prices resulting in poor investing outcomes. Ultimately, most of these companies have continued to be successful and are still household names today. The lesson here for investors is that the stocks were extremely expensive given the future outcomes. It took an extended time horizon for investment growth to eventuate.

Phil Fisher’s approach to growth stocks

Phil Fisher, author of Common Stocks, Uncommon Profits, speaks about how to choose growth stocks that are right for an investor’s situation.

He believes that the key for investing in growth stocks is finding quality at a good price.

The key is a long-term outlook, for investors and the company

Many investors know how important a long-term time horizon is for building wealth. The same goes for companies. Fisher thinks that many companies are too focused on near-term earnings. This focus means they may forego taking actions that will benefit the growth of the company in the long-term to avoid a short-term hit to earnings.

A CEO’s main job is capital allocation. They must decide where funds are being directed and for what purpose. There must be a balance between rewarding existing shareholders with immediate income, through the form of dividends, and investing back into the business to ensure that the business continues to grow.

Fisher addresses the emphasis that investors place on this short-term reward, that can, and has, come at the detriment of long-term growth for the company. These pressures result in not investing in the business and instead keeping earnings and dividend payouts high, whether it is in the best interests of the business.

The two types of growth stocks

Fisher then moves on to speak about how to choose growth stocks that are right for your situation.

The book contains a list of 15 factors but focuses in on what to buy and how to apply it to your own needs. This is where he speaks about risk and return. He thinks investors should focus on stocks that have the highest profit comparative to risk but acknowledges that circumstances differ from person to person and to invest according to your circumstances.

These circumstances for growth stocks are separated into two broad categories:

1. Larger, more conservative growth stocks – for example, Apple. These stocks have temporary volatility like all stocks, but over time, they’ll reward you with growth and decent dividend yields along the way.

2. Smaller growth companies. These companies can be much more profitable as there’s more room to grow, but with that, comes risk. These are the textbook growth companies that are reinvesting all their funds in the future growth of the business – and this means that they would pay little to no dividend but may reward investors handsomely with stellar growth.

Phil liked the latter – but he knows that not everyone is in a situation where they can forego income from their investments. He understands why those larger, more conservative stocks do have a place in some investors’ portfolios.

Finding the right investment for you

The right investment to achieve your goals may be a combination of both large and small growth companies. You may invest the majority of your portfolio in blue chip shares and a portion on smaller companies that are riskier, but also have higher future potential.
The key is to ensure that you have conviction in the prospects of the company. One way to do this is by using a tool that our analysts include in their research reports – a bulls say, bears say list.

For example, Nvidia.

Source: Morningstar Investor, Nvidia analyst report (at 29 April 2024)

Understanding the pros and cons for a company provides an opportunity for an investor to reconsider or strengthen convictions. Strengthening your conviction in the prospects of the company and fully understanding the variables that might change these prospects allows you to confidently invest over longer time horizons.

The other factor that investors can look for is a moat, or potential sources of a moat for smaller companies. Over long-time horizons moats have increased the safety of an investment, as businesses are able to maintain and grow their sustainable competitive advantages.