There is a big difference between a growth stock and a company that grows.
…the term “growth stock” is meaningless; a growth stock can be identified only in hindsight — it is simply a stock which went way up. But the concept of “growth company” can be used to identify the most creative, most imaginative management groups; and if, in addition, their stocks are valued at a reasonable ratio…over a period of time, the odds are favorable for appreciation in the future. — Peter Bernstein
Bernstein believed that investors needed to separate “growth stocks” from “growth companies.” Because one was a label slapped on anything with a high price relative to earnings or assets. The other had a few characteristics that made it a rare exception in the business world.
The way Bernstein describes it, a growth company held an advantage that allowed it to grow over a long period of time. What he describes sounds awfully similar to some characteristics of moats. That Bernstein wrote about it in 1956, shows how early he was to the discussion.
And those characteristics:
- “The ability to create its own market is the strategic, the dominating, and the single most distinguishing characteristic of a true growth company.”
- The company’s products have above-average profit margins.
- The company’s products may have little to no price competition.
- The company is constantly improving products, developing new products, or creating new markets for existing products, which help insulate it from economic trends.
- The company “is a nonconformist in economic society. It adapts the outside world to itself by creating something or a demand for something which did not exist before, instead of adapting itself to changes in the outside world.”
- The company is a pioneer in its industry using technology, merchandising, product development, production, or geography to keep it at the forefront.
- The product has a strong brand loyalty that drives consumers to abandon the competition, creating growth in market share.
- The company shows more consistent than normal growth in earnings over many years. And if it pays a dividend, the dividend gradually increases over time too.
- “Money which is reinvested instead of paid out should earn at least as much as the old capital which produced these earnings. This ratio is indeed the most significant indicator of management’s over-all ability and aggressiveness.”
- The company has a good chance of continued growth for years into the future.
- A low ratio of price to increase-in-earnings should help separate the true growth from the faux growth companies.*
It reads like an early edition of a checklist for moats. Not bad considering it was written 64 years ago. Though, you may want to update it before using it.
Of course, the hard part is still in assessing the qualitative side. Anyone can look backward to find superior companies. Companies that exhibit a long runway for growth are never easy to identify in advance.
Even if you can, you still must buy the stock at a reasonable price that doesn’t have all its future growth already priced in.
No amount of study in this area can minimize the importance of trying to buy at a fair price; buying at any price and hoping that the future will take care of itself is a good short cut to disappointing results.
* Note: Bernstein introduced the ratio of price to increase-in-earnings to identify true growth companies in a basket of “growth stocks” with similarly high P/E ratios. A lower price to increase-in-earnings is better, where increase-in-earnings is based on the change in earnings over a five year period. He made sure to adjust for any “windfall” earnings jumps from the likes of a one-time government contract or something similar.
The idea is that a growth stock with a high price to increase-in-earnings combined with a high P/E ratio is more likely to be just an overpriced stock. As Bernstein puts it, “The ratio of price to increase-in-earnings makes some stocks look cheaper and some more expensive than the values indicated by the more conventional price/earnings measurement…the companies with superior financial results almost always appear to be more attractively priced on the new basis.”
The idea of comparing the change in earnings over a period of time is not new but I’ve never seen it used as a ratio before. Apparently, Bernstein’s ratio didn’t catch on. And while it makes sense, his example was based on a one-year backtest that obviously worked out great. His one-year backtest of low P/E and low price to increase-in-earnings also did well. I wonder how it would perform in thorough backtests across current value metrics.
Growth Companies vs. Growth Stocks, HBR 1956
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