When investors like us invest in the stock market, the goal is always trying to grow our wealth over time.
Investors are generally thrilled by the prospect of growth in general, whether they are referring to their income, savings or even the companies that they invest in.
We just love things going in the “up” and “grow” direction.
It is so tempting for investors to see their companies growing by double digit each year because i.) they expect the management to take the shareholder’s earnings and reinvest them to propel for further growth or ii.) Higher growth means higher dividends that the management can decide to payout or iii.) the share price would eventually re-adjust themselves to the same valuation.
What do I mean by that?
For example, Colgate’s share price is $63 today. If Colgate’s valuation based on price to earnings ratio is currently at 20x and the company prospects a guidance growth of 10% per annum over the next 3 years, then the forward price to earnings ratio at the end of the 3 years is expected to be at 14x. Most of the time, the market will not allow such scenario to happen and upon the announcement of the news, the share price would adjust itself to the range up to $84 such that the valuation of the company goes back to 20x.
Of course, such scenario is a very simplistic way of putting it in mathematical form.
In reality, we all know that not everything will go according to plan in the next 3 years.
Well, mostly in that sense.
From a downturn to the economy to the change in the fiscal or monetary policy of the macroeconomic factor or the company could have internal labour, production or acquisition issues that they did not anticipate for. There could be a scandal in the making or a new competitor coming in with better quality and cheaper products. The possibility of any event happening in the 3 years is seamless.
The problem is the share price has usually priced the news in earlier before allowing what the company can really perform.
The market is often forward looking and that’s when most investors get caught in their pants, i.e buying when the valuation is high.
Most investors notice the prospects of a “good” investment only either when their friends tell them or when they read about it on the newspaper. By the time they put their foot on the water, most if not all of the good news have been baked in and the investor is left to pick up the mess should anything goes wrong or if the company is not able to meet the ambitious guidance they project.
Unless you are a damn good timer in exiting the market, the investor who uses this strategy are most likely to end up poorer over time.
Growth investing also has the tendency to caution the day when finally that growth slows down.
You can’t have a company that grows perpetually and exponentially higher growth each year.
At some point, the company is going to register a slower growth and when that happens the market is going to take it quite badly, re-adjusting to the slower growth outlook for the valuation it entails.
I don’t have a good strategy to go long on growth companies because I’m always skeptical about either what the management say or what the world might crap on me.
Being in the financial and accounting sector myself doing forecast for the past 10 years of my work experience, I’ve seen almost every single time the forecast has gone haywire, even if they are only for the next 3-6 months, let alone multi-running years.
It is also extremely difficult to spot on the very few companies in their early stage of growth and then ride on them because it entails a lot more expertise on the sectors you are eyeing for (almost like going for a private equity seed stage).
I’m interested to listen though to the strategy of those who’ve been investing in growth companies for some time with some measurable success and how they decide to enter and exit and what are their cautious approach to not being caught.
Let me know in the comments below.
Thanks for reading.
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