If you were to ask someone about his favorite stock, the odds are that the idea would be a company with high growth prospects. This extreme bias in favor of growth is quite pervasive. You will it in analyst reports, on TV and on discussion boards too.
The flip side is that if you mention a company with low or poor growth prospects, the other person is completely surprised. It is like you have belched in a social gathering!!
The problem is that almost everyone favors growth without really thinking about it. It is almost a herd like behavior where we have been conditioned to prefer companies with high growth prospects.
Is growth always good?
Growth in a company is usually a good thing, though not always. It is not written in stone that if you buy a high growth company, you will make good returns. There is more to investing than just growth. The value of a company depends on the following factors
- Does the company earn more than the cost of capital? More the better
- How long will the company earn more than the cost of capital? This is known as the competitive advantage period. Longer the better
- If the company earns more than the cost of capital, growth is good and adds value.
So anytime you look at a company with high growth prospects, think of the following points
- Is the company earning more than the cost of capital and how sustainable is it? remember that companies earning high returns with high growth rates attract a lot of competition. Competition in turn drives down growth and return on capital
- How sustainable is the growth of the company?
- Does the valuation discount the growth already? I have seen a lot of people miss this point completely and overpay for growth most of the times.
The above factors are quite subjective and not really quantifiable. As a result high growth investing is not easy, requires more experience and judgment and there is a bigger chance of getting it wrong
Missing other opportunities
The flip side of focusing on growth alone results in missing opportunities where the growth of company is low or non-existent. Low growth industries are characterized by a lower competition, moderate competition and fewer companies with some enjoying a dominant position in the industry.
It is far easier to find a mispriced company in such situations as there are fewer investors following these companies.