The illustration below (taken from the Toolkit 6 user’s guide) shows the common path a company can take from startup through success (and beyond).
At left, a new business starts and typically begins to lose money immediately, as evidenced by the drop below the line representing the break-even point. Buying the stock of a company in this phase can’t really be considered “investing”—it’s far too speculative to deploy more than a small percentage of your portfolio to these kinds of ventures. Many of these businesses will never find success and will see their shares end up in the penny stock market. As a general rule, we eschew holding the stocks of these companies.
Gradually, though, a well-managed startup will earn its way above the break-even point. Sales and earnings are growing at an explosive rate. Business is good.
Eventually, however, that company’s annualized growth rate must slow as the dollar amounts of its sales and earnings reach higher and higher levels. An increase in sales of 50% for a company with net income of $100 million requires an achievable additional $50 million in sales in the next year.
According to the law of large numbers, it becomes increasingly difficult (well-nigh impossible, in fact) for a company with income of $50 billion to increase its earnings by $25 billion in a single year in order to achieve that same 50% growth.
Consider Wal-Mart, which sold $485 billion worth of merchandise in fiscal 2014. The sheer size of its company illustrates the law of large numbers at work. Wal-Mart’s sales have been increasing on average less than 4% a year for the past few years. There simply isn’t enough of a potential market for them to grow as fast as they did in the 1990s.
As growth slows, companies enter the mature growth phase, where single or low-double digit annual growth of sales and earnings is possible for an extended period.
Few good things last forever, so companies may see their growth stabilize at levels below which growth stock investors are uninterested; these companies rely on paying out a significant dividend to attract shareholders.
Other companies go into decline, becoming relics of an earlier age, and relying on their past reputations to prop up their share prices. Antique furniture is often attractive to purchase; antique companies are seldom so.
As the illustration shows, growth investors should look for opportunities in the explosive and mature growth phases. Explosive growth companies often command high P/E ratios that deter sensible, value-minded investors, but when those companies become reasonably-priced, they can provide outsized rewards.
When companies reach the mature growth phase, much of their business is known by investors, leading to fewer—but plentiful enough—opportunities for long-term investors.
One hazard comes from misidentifying the phase in which a company is currently inhabiting. Buying a mature growth business that is in reality a company in decline is a sure recipe for disappointment. Buying a company in the explosive growth stage but treating it like a mature growth company will often provide some unexpected shocks as momentum investors and traders bail out as growth slows.
The periods at which a company changes from one phase to another can also introduce uncertainty in your analysis. It may take several years for a company to transition from explosive growth to mature growth, all the while leaving the market and investors in a whirlpool of uncertainty.
From the perspective of investors following a growth-at-a-reasonable-price-approach, companies in transition often appear to be inexpensive relative to their future, slower growth potential, but the rest of the market is looking back in time and finding the company’s prospects to wither in comparison. In time, memories fade and the new understanding of a company’s potential comes to be known and understood, but in the interim, investors who follow our approach may be frustrated.
One valuable exercise that investors should consider is a review of their stock holdings, identifying the stage of each in its company life cycle. This can provide insight into the growth potential of each company in the coming few years.
- DOUGLAS GERLACH