Online Investing Hacks

Investing in Growth

When companies increase their earnings over time, the companies become more valuable. Higher earnings can lead to more assets owned, more money to invest in producing additional growth, higher dividends paid out, and higher shareholders’ equity in the company. As the value of a company increases, investors are willing to pay more to own it, so the price of the company’s stock increases as well.

Investing in growth companies is easier than you might think. Once you know what to look for, growing companies are easy to recognize and easy to track. With growth companies as investments, you don’t have to worry too much about whether the stock market is up or down, where a company is in its business cycle, or whether a company’s turnaround strategy is successful. You can review financial performance when a company publishes a new quarterly report every three months to see if it’s still on track. As long as the company continues to grow earnings at a healthy pace, its stock price should increase as well.

Tip

Investing in growth companies is not a zero-sum game; as these companies grow, the size of the growth company pie grows larger, which means that every investor who invests in growth companies can make money.

So, what does financial growth look like? When you’re looking for investments, a small amount of growth doesn’t quite cut it. First, growth companies have to increase their sales and earnings faster than the combined growth of the economy and inflation. The growth companies you want to own also tend to grow faster than most of their industry competitors. Consistency is also good. If a company has grown consistently through thick and thin, it’s more likely to weather future storms with equal aplomb. If you don’t like the roller coaster at the amusement park, you’ll like it even less when it’s your money on the ride.

Just like children, companies don’t grow at the same pace over the years. When companies are young and offer revolutionary new products with no competition, their growth can be explosive. The problem with these shooting stars is their risk. New technology can transform products from revolutionary to revoltingly passé. Tastes can change. Competition can eat a young company’s lunch. And, trying to keep a place at the table can chew through cash flow. As companies expand, their growth usually slows down. Bureaucracy, competition, and the drag of the past all take their toll. However, larger companies also have more resources, and that often means less risk and years of consistent growth—a fundamental investor’s dream. Unfortunately, some companies can’t keep up with the times. When products and services aren’t modernized or rejuvenated, growth can stall or even turn into decline, and that’s a clear sign to find another investment. Table 4-1 shows the guidelines suggested by the National Association of Investors Corporation (NAIC) for growth rates for companies of different sizes.

Table 4-1. Minimum suggested growth rates by company size

Company size in annual sales	Suggested minimum growth rate
Small, less than $500 million	15 percent
Medium, from $500 million to $5 billion	10 percent
Large, greater than $5 billion	7 percent

Companies can grow their businesses in several ways, such as introducing new products, increasing their share of the market, building new stores, expanding into new territories, or acquiring competitors. Sure, some companies skyrocket to fame with a hot new product, but consumer tastes change as quickly as hemlines. The key to long-term growth is great management—a leadership team able to maintain quality while controlling costs, introduce new products and services without getting stuck with obsolete inventory, and beat the competition no matter how intense.

To choose good growth stocks and monitor their performance, you need to examine the growth rates of financial factors over time. Simple percentages are easy to calculate [Hack #25] and are good for rough estimates. Compound growth rates [Hack #26] take a little more work, but they can help you evaluate both quantity and quality

Starting with Simple Percentages

On October 27, 1997, the Dow Jones Industrial Average fell 554 points, the largest one-day point drop in history, even surpassing the decline on “Black Monday” a decade earlier when the Dow fell 508 points on October 18, 1987. While both tumbles sparked a bit of panic for many investors, was the 1997 plunge worse than that dark day in 1987? Hardly. To get some perspective on both events, consider the percentage change in the Dow’s performance for each day. In 1997, that 554-point fall turned out to be a 7 percent decline for the day, whereas in 1987, the 508 point drop cut a whopping 23 percent out of the Dow. Clearly, 1987’s “Black Monday” was far worse for investors.

Percentages are just as helpful in many other areas of investment analysis, whether you’re calculating the rate of return on an investment, comparing the growth rates of several companies, or considering the performance of your overall portfolio. For example, let’s say you bought stock in Amgen at $24 per share and now it’s selling for $48 a share. You’ve doubled your money, and the gain on your investment is easy to calculate—it’s 100 percent. Pretty sweet, right?

Before you get too excited about your investment prowess, there’s another factor to consider. That 100 percent gain is the overall appreciation of the stock’s price. It does not take into account the all-important element of time. If you bought your Amgen stock last year, doubling your money in roughly twelve months is a largely laudable accomplishment. However, if you bought the stock a decade ago, you might have failed miserably compared to the overall market. As it turns out, Amgen’s stock price closed at $8.83 a share in 1992 (adjusted for splits). Ten years later in 2002, the stock ended the year at $48.34 a share, which is an overall appreciation over the decade of 447.5 percent. Over the same period, the Standard & Poor’s 500 index increased from 435 to 879, an overall appreciation of only 102.1 percent.

The Value of Compounded Growth

To obtain a measure of stock performance that you can compare to other investments or your investment guidelines, you can calculate the return that you’ve earned on an annualized basis. Annualized return is also known as compounded annual return, compound annual growth rate (CAGR), or dollar-weighted return, because it includes the effects of compounding over time on the initial value.

Most likely, you were introduced to compounding when you were first taught how interest is calculated on a bank savings account. The interest rate (APR) advertised by banks is the annual interest rate they pay on the balance in the account. However, the yield (APY) paid by the account is based on keeping your money in the account for a full year without removing any of the interest paid each month. The yield is higher than the interest rate because you earn interest on your deposit as well as on the interest paid by the bank.

A 100 percent increase in a stock’s price over ten years comes out to slightly more than 7 percent a year when calculated as CAGR.

Let’s use CAGR to evaluate your hypothetical investment in Amgen. On an annualized basis, a 447.5 percent increase over ten years comes out to compounded annual return of 18.5 percent—not too shabby compared to the 7.2 percent annualized growth of the S&P 500 index.

Tip

Occasionally, the same method of calculating growth rates is applied to periods shorter than one year. While it can be useful to look at annualized rates of return, these can be wildly inflated if the stock, mutual fund, or other investment has seen a significant short-term fluctuation in one direction or another. If the share price of your new stock popped shortly after your purchase, your annualized rate of return might turn out to be several hundred (or thousand!) percent. However, you would be seriously disappointed if you expected your actual returns for an entire year to be anywhere near that result.