As I become more mature (translate: gotten older), my investment philosophy has slowly evolved into a more conservative posture. When I was a younger investor I felt I had time on my side, and therefore, was willing to take on greater risk as long as I believed that greater rewards could follow. In other words, if I made a mistake by investing in an aggressive and more risky growth stock that went badly, I felt I had adequate time to overcome or recover my losses. Consequently, as a younger investor I relished a good growth stock.
At this point I think it’s important to point out that my currently more conservative attitude towards investing in more conservative dividend paying stocks is not driven by fear. Thankfully, my long experience as a fundamental stock investor has taught me not to be afraid of stock market volatility. Instead, I feel I’m simply being a realist for a couple of important reasons. First of all, I believe that time in the market is more important than timing. But unfortunately, as a more mature individual I must acknowledge the reality that I do not have the time luxury I once did as a younger man. Second, I now have less of the need to build wealth coupled with a greater need and requirement for current income.
Consequently, my investment philosophy has morphed from pure growth into a growth and dividend income strategy. On the other hand, I have not completely forsaken my desire for capital appreciation because I also understand the reality of inflation. Therefore, for the most part I still look for above-average high quality growing blue-chip companies that can give me both attractive capital appreciation and dividend income growth. This is where the bulk of my investing has been in recent years, and in future articles in this series I will cover various categories of dividend growth stocks.
On the other hand, even today I still appreciate the powerful returns that a good growth stock offers. Therefore, I still allocate a portion of my investments into pure growth stocks. However, growth stock investing represents only a small part of my portfolio today. Because, as I hope to illustrate in this, part 2 of this series, which is focused primarily on pure unadulterated growth stocks, even a small allocation of growth stocks can produce game changing future returns. With these thoughts in mind, I believe that all common stock investors, regardless of their age or status, might be well served to sprinkle in a bit of growth. And of course, diversification among the growth portion can serve to mitigate some of the associated risks.
Growth Stocks Defined
Before I get too deep into this discussion on growth stocks, I feel it’s important that the reader understands my definition of what a growth stock is. The term “growth stock” suffers, as many other investing terms do, from what is often a cavalier or loose definition of what it truly is. Many investors and writers think of growth stocks as companies with high P/E ratios or high betas. However, neither of those characteristics are always representative of a true growth stock, at least by my definition.
In order for me to consider a company a growth stock, it must possess a record of consistent earnings growth exceeding 15% a year or better. When I think of a growth stock, my focus is on the growth of the business. Because, as a long-term investor I believe I am buying the future earnings power of the company under consideration. Consequently, the faster a company grows its earnings, the more future earnings I can expect to receive. But even more importantly, thanks to the power of compounding, I expect to receive significantly greater earnings sooner from a true growth stock than I can from an average growing business.
Moreover, since I understand that the market is always capitalizing earnings, the more earnings a business delivers me, the more future capital appreciation I can expect to receive. Therefore, a true growth stock that delivers above-average earnings growth can actually be less risky than many investors believe them to be. Of course, this is only true if the company delivers the faster earnings growth that I anticipate. But when it does, I can expect a decent return even if the company’s future P/E ratio is less than I paid today. I refer to this as the power and protection of high compounding earnings growth.
The Power and Protection of High Compounding Earnings Growth
The review of a simple compounding table illustrates my points better than words. What actually happens as a result of faster earnings growth is that it shortens the time it takes to double earnings. Therefore, the following compounding table illustrates how an original $1.00 worth of earnings that are purchased today will double more often over a 10-year timeframe when earnings growth is higher. The tipping point becomes rather dramatic at 15% per annum or better.
People that do not understand the powerful force of compounding will often mistakenly assume that a 20% growth rate will produce twice as much future earnings as a 10% growth rate. However, compounding is more about geometry than it is simple mathematics. From the table below, note that $1.00 invested today that grows by 10% per annum does not double until the 8th year. In contrast, $1.00 invested at 20% doubles in the 4th year, and then again in the 8th year. Therefore, doubling the growth rate from 10% to 20% doubles the number of doubles on your earnings in 10 years. This compounding effect is even more dramatic when you look at what happens with various growth rates by the 10th year.
Increase the growth rate to 30%, and that first dollar will double 3 times instead of only once. Consequently, it is easy to understand why Albert Einstein said: “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” Compounding is the power; and the higher level of earnings it produces is the protection that high-growth stocks can provide. However, earning high rates of earnings growth over an extended period of time is quite difficult. Few companies are capable of achieving high earnings growth, and therein resides the risk of growth stock investing.
Growth Stocks Are Not Your Grandfather’s Buick
At this point, I think it’s important to point out that investing in growth stocks is entirely different than investing in blue-chip dividend paying stocks. Growth stock investing along with greater profit potential also provides greater challenges and risks than investing in lower growth alternatives. For example, although investing at fair value (which I consider to be when the P/E ratio is equal to or lower than the earnings growth rate) will provide strong returns at reasonable levels of risk, assuming of course that the earnings growth materializes.
On the other hand, due to the power of compounding discussed above, you can actually overpay for a growth stock, and still achieve above-average long-term returns. However, by doing this you do assume a high level of short-term risk, even though long-term returns might still prove