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T. Rowe Price’s Recipe for Growth Stocks

April 9, 2021 by Jon

“Growth stock” investing was a new idea that arose in the 1930s. Thomas Rowe Price was one of the founders of the theory. He publicly make the case for it in 1939.

Price recognized early in his career that a few companies had an advantage of stable long-term growth. They could plow earnings back into the company and grow for decades. Those were the companies he wanted to own.

He explained in a series of articles appropriately called “Picking ‘Growth’ Stocks.” He defined it like this:

“Growth stocks” can be defined as shares in business enterprises which have demonstrated favorable underlying long-term growth in earnings and which, after careful research study, give indications of continued secular growth in the future.

A decade later he refined his definition in a follow-up article:

A share in a business enterprise which has demonstrated long-term growth of earnings, reaching a new high level per share at the peak of each subsequent major business cycle and which, after careful research, gives indications of continued growth at a rate faster than the rise in the cost of living.

He also included eight factors he looked for in a growth company:

  1. Management must be aggressive, efficient, understand social trends and have the good will of its employees. Directors and officers should have substantial stock ownership in their companies, the value of which and the income of which are not overshadowed by excessive salaries and pensions.
  2. Intelligent research which develops new products, new markets for existing products, or both, is essential if a company is to forge ahead in a rapidly changing world…
  3. Competition of a cut-throat nature should be guarded against, as it impedes growth.
  4. Finances must be strong enough to permit companies to weather periods of adverse earnings.
  5. Return on invested capital must be reasonable — 8% or above — and not experiencing a long-term decline of dangerous magnitude. Investors should seek a company that can lower the cost of production and develop an expanding market without materially reducing the return on capital invested in the business.
  6. Profit margins before taxes must be reasonable, the percentage varying with the industry.
  7. Socialistic infuences restrict earnings. Companies whose actions are circumscribed by government regulation of rates, wages, and profits should be avoided.
  8. Employees should be well paid, but the total payroll should be relatively low and easily adjusted to changes in business volume.

Price’s process started with a large list of potential candidates which he whittled down to a portfolio of 25 to 40 names.

Price was clear that no company would fit every criterion but management was the most important. Without capable management, the rest is unlikely to fall into place.

He also points out that “no mathematical formula or yardstick alone can be relied upon for identifying Growth stocks.” His criteria can’t be easily measured with a few metrics. Growth investing requires the ability to look beyond fundamentals. That’s where the hard part begins.

In fact, fundamentals alone can be deceiving. Sales growth, for instance, is no guarantee that earnings growth will follow. Along similar lines, a high P/E multiple says nothing about a company’s future growth potential. It only says that the price of the stock rose and/or the earnings per share fell (interestingly, Price doesn’t mention stock price/valuation at all, maybe I missed it).

Of course, predicting the next 5-10 years for any company is difficult. Now try to find the handful that outperforms the rest. Not only do you have to constantly evaluate a company’s future potential — the management, the size of the market, the product pipeline, etc. — but also the competition, consumer/social trends, and the possibility that something new comes along to make a product obsolete.

Here’s the thing. Most growth stocks have limits. Eventually, companies mature, growth declines, and those growthy stock returns disappear. Only a few rare companies have continued sustainable growth — those companies with moats discussed so often — after they reach maturity.

In putting together his final picks, Price estimated that, on average, only 25% would be long-term growth stocks worth owning. He expected to be wrong 75% of the time! He knew how difficult it was to find the rare growth companies but he also knew that being right on the 25%, more than made up for the 75% he was wrong on…so long as he held on.

Because a long-term holding period is required to reap the rewards of growth stocks — a holding period certain to experience major swings in the stock’s price.

Source:
Picking “Growth” Stocks, Barron’s 1939
Picking Growth Stocks for the 1950s, Barron’s 1950

Last Call

  • The Big Lessons of the Last Year – M. Housel
  • Actionable Complexity – The Better Letter
  • Death to the Lost Decade – Verdad
  • Searching for Superstars – Sparkline Capital
  • “Buy and Hold” No More: The Resurgence of Active Trading – a16z
  • We Might Be in a Bubble, But You Probably Shouldn’t Care – ValIdea
  • Bridge To Nowhere – Tedium
  • The Hydrogen Revolution in the Skies – BBC
  • Adding is Favored Over Subtracting in Problem Solving – Nature
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