Saturday, July 29, 2006

Mad rush for high growth

  1. If the investing public in general, anticipates growth then the prices move up. Many times this rise in prices negates any advantage that the investor would get if the growth did materialize
  2. If the prices are high you are essentially paying for a future which has not yet materialized. [compare this with paying for the assets which exist as of now]
  3. As the business conditions are subject to change there is a risk involved in paying for growth. Higher the expected growth, higher the risk.
    1. If you are expecting 27% per annum growth for 20 years and the company grows at 24.3% for 20 years, you have been amazingly accurate in your prediction. Your forecast is just 2.7%(0.1G) off the mark. But the accumulated profits in these 20 years would be 30% less than what you forecasted and the profit in the terminal year would be 35% less than your forecast. If you paid for this high growth you may end up loosing even after this stellar clairvoyance.
    2. For a 10% growth prediction the same 0.1G, i.e. 1% forecasting error would result in only 12% and 17% hit to accumulated profits and terminal year profits.
  4. Its easy to overrate growth expectations. If a company has grown at a rate of 50% p.a. in last 5 years and future looks bright, can I expect the CAGR of 27% p.a. for next 20 years. Its very difficult. If the company grows at CAGR of 27% for 20 years its profits would be 119 times current profits. Given that the company had grown 50% p.a. in last 5 years, the profits 20 years later would be staggering 904 times the profits it had 5 years ago. The question arises
    1. Does the company has management capacity and vision to achieve this? Scaling up 904 times in 25 years is almost impossible(except for startups which have low base).
    2. Even with 10% p.a. productivity enhancements, this would require 17.7 times resources. It can be capital or human resource. Can the company raise so many resources?
    3. If the future is indeed that bright many more competitors would join the fray. The margins would go down due to law of diminishing returns. Can you expect the revenues to grow more than 119 times?
    4. Suppose the company has 10% market share of the industry. If the industry grows at 15% in the same period the market share of this company would rise to 72.7%, almost a monopolistic level. What is the strength that makes you assume that this company would become a monopoly in 20 years.
  5. The more you look at these arguments the more you would realize the fallacy of the growth assumptions. When you do this you become averse to paying high for high growth. I would love to buy a growing company if I don’t have to pay an extra dime for that growth. The profits of M&M, Sterlite, Jindal have grown as fast as market favorites like Infosys, Wipro. But I paid P/E of 2-5 compared to p/E of 25-40 commanded by Infosys, Wipro. When the growth materialized I gained 20 to 30 times appreciation. If the companies were to fail and go bankrupt I would have got out without significant loss because the price paid was 50% less than the market value of the assets. Such valuations look highly improbable now but the markets have history of manic depressive syndromes. So its better to wait patiently when markets are in manic phases.
  6. Finally what makes you think that the underdogs wont turn the tables. In 2002 SAIL was deep in red. It reported loss of 1707 crs. You may have thought SAIL would go bankrupt, but it bounced back to profitability. In FY05 the profits were 6817 crs., in FY06 4013 crs. Needless to say stock price jumped through the roof.
  7. Growth is good. We all want our companies to grow. But we want them to grow more than the growth that’s already built into prices. Absolute growth number is meaningless and its pursuit has been one of main blunders, the money managers have made throughout the financial history[I’ll explain this some other day].

1 comment:


Growth stock investing is all about buying a companies future expectations. But who really knows what their future holds.