Before I proceed, it might be necessary to
define what, in my opinion, constitute as a growth stock.
A growth stock is primarily a stock that
is/has
-a high price-to-earning ratio, with
earnings averaged out over many years, preferably 10 years (do note that
cyclical companies usually have low PE ratios during bad years and high during
good years).
-astronomical price-to-cashflow.
-companies which, in essence use its assets
to generate revenue, and has a very high price to book ratio. This exclude
firms that are mainly in the service industry, or does not own assets.
-a company with exponential revenue or
order book growth that might (!) not be followed by an equivalent increase in
cashflow or return on capital (ROC).
-rapid uptrend in prices, highly valued by
the market, due to promise or just plain hot air of promise.
A growth stock might include one or all of
the factors above.
Growth does not translate into an
increase in profitability
A company that managed to increase its EPS
from 50 cents to a dollar looks attractive until you realized that the capital
invested increased five-folds. In short, the company has became less efficient.
My favorite metric is to use ROC to
evaluate a company’s performance over at least 10 years. It does give off the
warning bells very early for me.
Widely Followed
Everyone can read a bar chart—especially one
that has increasing profits. What are the chances of institutions and traders,
who are doing this full time, missing out on stocks like this? Everyone loves a
good story, and chances are, if human beings give in to the temptation of both perceptively
easy profits and social trends (how many times are you tempted to try a food
stall just because the queue is really long?), the margin of safety for paying
for growth isn’t going to stay around for long.
Tough to value a growth stock
The basics of discounted cash flow
valuation comes from estimating a discount rate (higher discount rate for
riskier business models), an estimated cash flow for incoming year, and lastly
a growth rate. To compound this difficulty, an analyst has to input the growth rate
for a great number of years. This is why every time there is a disappointing
earning release, target prices from investment banks and brokerages for growth
stocks shift dramatically.
Higher possibility of disappointments
The market pays too much attention on earnings—a
whole lot of analysts are paid to guesstimate them. Quite often a company got
into a bit of hurdle (think Raffles Medical and its operating costs), from government
regulation (as what happen to Comfortdelgro’s bus business) to mere inertia and
market saturation (think Apple). Subsequently the company fails to deliver on
the numbers.
Competition
What happened to companies that were
selling those coffee buns in Singapore a number of years back? The bubble tea
mania? And now we have shops selling fidget spinners at almost 20 dollars? You
used to see them everywhere, but eventually they fizzle out.
Profits attract competition, and
competition erodes profits. It is very tough for businesses to build up some
kind of barrier to competition (or what is popularly known as moat), and even
more so for small business, which made up most of the stocks in the market.
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