November 7, 2008

The infatuation with growth

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.

Mental checklist
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.

22 comments:

Ninad Kunder said...

Hi Rohit

Good post. The survivor bias really creeps in where ppl only remember the businesses that made it on the promise.

We tend to forget a lot of businesses that dont make it and destroy value and capital.

Cheers

Ninad

Vic said...

Good post. I really liked your point "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." This is so true even though it is one of the most important point.

Also, like you said "It is far easier to find a mispriced company in such situations as there are fewer investors following these companies." I sense that in bear markets, we have more of these opportunities than in Bull run, what do you think?

Thanks,

Vikas

Neerav said...

Rohit,

I get your point - what you are trying to say is that ROCE should be a primary measure and if we are not obsessed with growth look into non glamorous sectors and identify companies with distinct competitive advantage.

I guess criteria here is stability of ROCE in future.

Only problem is that I can't seem to think of any such companies through my experience.

Vidyanshu said...

Hi Rohit,

I suppose at the end of the day the basic questions one should be asking is -
1. How much will it cost?
2. What is the return I can expect?
3. The probability factor - what is the risk and what is the probability of the return?

After these questions are answered one should allocate capital. Everything else is a label - growth, cyclical whatever balderdash you want to call it.

In that sense, Graham was remarkably clear headed and focused.

Best,
Vidyanshu.

Anonymous said...

Hi Rohit,

I read your blogs quite frequently.
I follow on the same lines of value investing.

in US, they have a website i.e EDGAR which lists all the snapshots of the companies and even Management Discussions...

Do we have a similar website for Indian companies.
I look at moneycontrol, bse and nse websites. but cannot find the Real 10K and 10Q reports.

Regards,
Fazalhusein Z Patvi
London, UK.

Rohit Chauhan said...

Hi ninad
i agree. everyone remembers a PRIL or an infosys and use that as an example. however most forget of dozens of other companies which never made it. the odds of investing in the next infosys or PRIL in a new industry are generally low.

regards
rohit

Rohit Chauhan said...

hi vikas
yes, you will find more attractive opportunities in a bear market. also some really good companies with good long prospects are available now at a good prices. will be posting on some soon.

neerav
stability of high ROCE is crucial. the key to finding such companies is to find companies which have sustainable competitive advantages. there are several such companies such HUL, infosys, ITC, gujarat gas, crisil etc. the more diffcult part is ofcourse finding such companies at attractive valuations.

regards
rohit

Rohit Chauhan said...

hi vidyanshu
true. guess that is why graham is considered the father of value investing. his writings and books are truly timeless.
warren buffett has said something on the same lines - growth and value investing is just fuzzy thinking
regards
rohit

Rohit Chauhan said...

hi fazal
you can get the same data through EDIFAR database in india.

regards
rohit

Anonymous said...

Hi Rohit,

One question: in value investing, an investor believes that a stock is selling at <= 50paise on a rupee and buys it. If you go by that, unless there are others who buy this stock blindly at a higher (or @~full value) price, the investor may not realize the returns at full value of the business. Now, typically, it's very rare that people (read: traders) flock to such stocks because it's 'unattractive' ot it does not contain 'Reliance' in its name. So, how will the stock ever attain the near-full-value? So, isn't it better to allot a good portiion of the portfolio to high risk-reward stocks as well?
Please note, this is a question only to understand your thinking pattern better.

Prashanth

Anonymous said...

Hi Rohit,

Just to add to my question: I understand that value investing is not just buying cheap companies, but you buy good companies. But, if you extrapolate that, and assuming that most people start to follow value investing principle, then we are drifting towards an efficient market situation, aren't we?

Thanks! Prashanth

Vic said...

Prashanth,

Excellent question!!

My guess would be that eventually masses will notice the value of the company, therefore buying the stock and increasing its price.

Also, not everybody is willing to take the risk when a stock is undervalued.

I'll let Rohit come up with detailed and precise answer..:-)

Vikas

Rohit Chauhan said...

Hi prashant
good questions. i will try to answer in more detail in a post.
these questions have been asked of graham (who is considered the original guru of value investing) and warren buffett.
their answer was - in the short term the market is a voting machine ..runs based on emotions of the market. but in the long term the market is a wieghing machine which values the stock based on the intrinsic value . i will elaborate more in a post.

regarding the second question - i dont think that will happen anytime soon. value investing has been know for more than 50+ years. however very few people follow it. it does not suit the temprament of most people and does not offer any excitement.
even in india i would say that 90% or more people prefer trading than value investing

regards
rohit

Anonymous said...

Hi Rohit,

It's so nice of you, your willingness to share and discuss ideas are just great for beginners like me. I will be, as always, waiting to hear more from you.

I have been trying to understand the behavioural aspects of investing. Developing a temperament (I bet value investing temperament is never in-born, for, our cave-dwelling ancestors have passed on one thing to us: RUN for your life when you see a trouble) is something I'm trying to work on. I have been fighting hard to curb my own tendencies to 'jump with both the feets off the ground' in to market when the temptation piles up. Your blog has been inspirational.

Thanks, Prashanth

VISHNU said...

Just add this conversation.. (This just an example)...

Efficient Market assumes that people don’t smoke because there is writing on the cigarette packet "Smoking is injurious to health" ..

(No offence to smokers /drinkers, incidentally most of the value investors I know are rational {teetotallers})

Regards
Vishnu

Vic said...

Prashanth,

Your're right, the behavioral aspect is very important in Investing and is extremely difficult to practice. Even the top professionals/Investment managers that manage million or bilion dollar portfolios have difficult time staying grounded.

I think it comes with experience. Especially during times like these, when there's so much uncertainty in the markets and world economy..one tends to drift away from AAP.

Sometimes I think it is a great opportunity to buy more stocks. At times, I think I should wait more (and move to Fixed income till cloud clears) as the prices might come down even further.

But eventually decide to stick to my AA as think and reflect on all the reading that I did over the years. Stay the Course!! :-)

Vikas

Rohit Chauhan said...

Hi vikas, prashanth

i think behavioural aspects and temprament are far far important than intellect alone. i have actually not written much about it and plan to do so.

buffett has mentioned that an IQ of 120 is good enough for an investor. anything above that may not be that important. although that is a bit of oversimplification of buffett, i think temprament is very crucial in investing. ability to think independently, and being rational beats genius level IQ in investing any time.

vikas - one suggestion. please leave your comment in the latest posts. what happens is that i can see the comment when i approve it, but then blogger does give the details on the post on which the comment was put. so after approving i have no idea where the comment is and cannot respond to it

regards
rohit

Vic said...

Will do. I assume you're referring to the comments that I posted to your 2005 posts..right?

I didn't want to hijack a thread, therefore had posted in relevant ones.

Thanks,

Vikas

Anonymous said...

Hi,
Rohit RK is having holding in the infomedia Ltd.(bseindia)can you throught some light on it.
Thanks

Vic said...

I think, it is under "Recent Comments" section.

Rohit Chauhan said...

hi vic
the recent comments widget is flaky ..sometimes it does not work and is currently configured for 3 comments ..so some comments get lost

regards
rohit

Rohit Chauhan said...

hi anonymous
i analysed the company sometime back..you can search on the blog using infomedia as the key word. how i am unable to see value in it. that does mean it does not have value ..clearly RJ is able to see something which is not apparent to me ..that is ofcourse my own limitation

however in such case if i cannot figure it out for myself , i will avoid the stock irrespective of who holds it

regards
rohit