There are two important phases that people should consider when investing in equities to fund all or part of their retirement. First there is the accumulation phase, representing the time when retirement is still many years away. But once retirement is taken, you enter the distribution phase when you need to start taking distributions from your portfolios. In theory, investors in the accumulation phase might logically be more concerned with maximizing total return. However, once in the distribution phase, current income tends to become the focal point.
In principle, this brings up some very important questions. Should investors in the accumulation phase simultaneously be more aggressive with their equities, or should investing for retirement always be approached as conservatively as possible? As it is with most financial concepts, the answer is it depends on the individual's own unique needs, objectives and risk tolerances. Moreover, the amount of capital available for investment could also be an important factor regarding what strategy you might choose or need to implement.
This brings me to a few comments on what has become a long-running debate, or even war, between dividend growth investors and total return investors. Frankly, I think the arguments border on the ridiculous, because in my way of thinking both are and/or can be viable choices. As I stated earlier, it really depends on the individual, and the strategies they are most comfortable with. Therefore, I find it hard to understand why the discussions become so heated.
However, regardless of which method you choose, I feel it's important that the investor has a clear handle on the advantages, disadvantages and risks associated with either strategy. In part one of this two-part series I discussed the important principle that not all stock price drops are the same. This applies equally to both investment strategies, total return (growth oriented) and dividend growth (income oriented). However, in part one the majority of what I wrote was oriented to the dividend growth investor. Here in part two my focus will move to investing for total return or investing in more growth-oriented common stocks. As previously stated, I do not believe that one is necessarily better than the other, or that one strategy is right and the other wrong. However, they are different for sure, and as a result have different types and levels of risk and reward associated with them respectively.
Therefore, one of my primary objectives with both articles in this series is to highlight some of the more important differences, and present both a few rational tactics and a clear awareness regarding what I believe it takes to succeed in either. In certain aspects, the differences are subtle, but in other areas profound. In other words, I support both approaches as long as the investor is fully cognizant of the risks, pitfalls and rewards of whichever strategy they choose to use. Personally, I utilize and covet both of these approaches - investing for total return, and dividend growth investing.
I like them both, but for different reasons, and I incorporate them both at different levels, and I always have. When I was younger, I had more growth in my portfolio, now that I am more mature, I hold more dividend growth investments. Most importantly, I don't argue with myself over which I feel is best. Instead, I recognize that both offer unique advantages, and both contain significantly different levels of risk. However, when I do assume more risk, I also expect more reward as a result, but sometimes risk bites you where it hurts. The rational investor should be prepared for those times when risk rears its ugly head. The best tactics are proper diversification and continuous monitoring and rigorous ongoing research.
Precisely Defining the Term: Growth Stock
Before I go any further with my discussions about investing for growth or total return, I think it's extremely important to define my terms. I take this position because experience has taught me that the financial industry is often very vague regarding how they define things. I believe that for true understanding to occur, we must be very precise with how we define the things we are attempting to analyze. Therefore, let me start with a few examples of how the finance industry defines a growth stock.
From InvestorWord's website I found this definition of a growth stock:
"Stock of a company which is growing earnings and/or revenue faster than its industry or the overall market. Such companies usually pay little or no dividends, preferring to use the income instead to finance further expansion."
I consider this a good start, but still a little vague. Investopedia explains a growth stock as follows:
"A growth stock usually does not pay a dividend, as the company would prefer to reinvest retained earnings in capital projects. Most technology companies are growth stocks. Note that a growth company's stock is not always classified as a growth stock. In fact, a growth company's stock is often undervalued."
To me, the Investopedia explanation is also vague, and additionally conflicting. This iteration indicates that an attribute of a growth stock would often be associated with undervaluation. This seems to be in conflict with academics such as Eugene Fama and Kenneth French who contend that growth stocks have high price-to-book ratios, and further contend that a growth stock is one that investors are willing to pay a high price for now, to stake a claim of what they expect will be exceptional future growth. To me, this academic definition implies that growth stocks tend to be overvalued.
Consequently, and for the purposes of this article, I define a true growth stock as follows: in order for me to consider a stock a growth stock, the company must have a history of growing their earnings in excess of 15% per annum, while simultaneously possessing a forecast expected future growth rate of at least 15% or better. The primary point that I wish the reader to glean from my definition is the focus on the growth of the business being the primary determinant qualifying it is a growth stock. To be clear, my definition of a growth stock would be more precisely stated as a growth company or business.
Still, even with my precise definition requiring a minimum 15% per annum earnings growth rate, there are lower rates of earnings growth that can also be technically referred to as growth. For example, a company that is growing earnings at rates of 5% per annum or less could be more precisely defined as a low-growth stock. However, even such low growth is nevertheless growth. Then there would be faster growing companies that grow their earnings from 5% to 15% per annum that could be defined as moderate-growth stocks, etc. Additionally, there also exists super-fast, or what I also think of as hyper- fast growing businesses with long histories of earnings growth above 15% per annum. In other words, there are many faces of growth.
For purposes of this article focusing on total return investing, I will be reviewing companies that meet my minimum earnings growth rate of 15% or better. However, I will also include examples of companies that fall into the super-fast or hyper-fast growth stock categories. In so doing, my objective is to bring to the reader's attention the incredible opportunities that total return, or growth investing, potentially offers. Conversely, my additional objective will be to highlight the greater risk that investments in these high-growth categories also possess.
Growth-Oriented Investing for Total Return
In order to accomplish the objectives stated above, I will turn to the F.A.S.T. Graphs™ research tool and provide various examples of true growth stocks to include a few examples of hyper-growth stocks. Since a picture is worth a thousand words, I will let the earnings and price correlated graphs with performance reports speak for themselves. However, with each example there are a few key focal points that I suggest the reader reviews.
First of all, look to the FAST FACTS boxes to the right of each graph and note the historical operating earnings growth rate on each example. Since these are all examples meeting my strict definition of a growth stock, the P/E ratio of the orange earnings justified valuation line will be equal to the company's operating earnings growth rate. In other words, each graph in this series is drawn utilizing the P/E = Earnings Growth Rate formula.
Next, I ask that the reader focus on the capital appreciation that each example achieves and how it closely correlates with the company's historical high earnings growth rate. This supports my long-standing contention that the rate of change of earnings growth determines capital appreciation. The idea is to gain a perspective on the performance power (total return) that investing in growth stocks can provide. To add further insight into this important principle, I will turn to Peter Lynch and one of his 20 Golden Rules:
"Often, there is no correlation between the success of a company's operations and the success of its stock over a few months or even a few years. In the long run, there is a 100% correlation between the success of the company and the success of its stock. This disparity is the key to making money; it pays to be patient, and to own successful companies."
Simultaneously, I believe that the careful examination of the graphics also reveal the risk associated with achieving high capital gain generated total returns. Achieving a high rate of earnings growth over an extended period of time is both difficult and rare. Moreover, I will cite a few examples illustrating the reality that exceptionally high growth tends to diminish over time. This is an important risk that all total return investors should keep at the forefront of their minds.
Note: For those readers that are not initiated as to how the F.A.S.T. Graphs™ research tool functions, I offer the following explanatory link.
Deckers Outdoor Corporation: (NASDAQ:DECK)
Deckers Outdoor Corporation operates as a designer, producer, marketer, and brand manager of footwear, apparel, and accessories. The company's footwear appeals to men, women, and children.
With this first example, I start out by providing a graph of earnings only for Deckers to focus the reader's attention on the operating success this company has achieved since 2001. This company reports earnings on a calendar year-end fiscal basis, and their only blemish was 2012. Nevertheless, operating earnings growth of 20.1% exceeds my 15% minimum threshold. More importantly, this earnings growth rate is almost 4 times higher than the 5.3% average earnings growth rate of the S&P 500 index.
Next, by overlaying monthly closing stock prices (the black line) over the orange earnings justified valuation line, important information is revealed. First of all, we see that stock price ultimately goes where earnings go over the long run. But, we also see shorter periods of time where price disconnects from its earnings justified valuation. Therefore, when we examine performance (capital appreciation) since 2001 we discover that long-term shareholders of this high-growth company received a powerful annualized return.
But, from a careful examination of stock price (the black line) we also find an example that vividly reveals the risk associated with achieving those high returns. The reader might ask themselves the following introspective questions. Could I have handled the significant price drops that occurred in calendar years 2005 and 2008 (the Great Recession) even though earnings continued to grow? Could I have further stayed the course when earnings fell by 29% in calendar year 2012 which led to a horrifying and precipitous drop in stock price?
Frankly, since most investors focus on stock price instead of operating results, I contend that few could have held on long enough to reap the rewards that investing in Deckers Outdoor Corp offered. Investing for high total return based solely on capital appreciation will test the nerve of even the most seasoned investors. Herein lays one of the greatest risks facing the total return investor. Stock price can not only be quite volatile, but also capriciously fickle at the same time.
Priceline.com Incorporated: (PCLN)
Priceline.com Incorporated operates as an online travel company that connects consumers wishing to make travel reservations with providers of travel services worldwide.
One of the great growth stories of modern time can be found by examining the earnings and price correlated graph of Priceline.com Incorporated. The company's historical operating earnings growth rate achievement has been extraordinary and consistent since 2004 averaging 50.6%. However, it's noteworthy that the company's normal P/E ratio (the dark blue line) over that same time frame has hovered around 26.1. In theory, a P/E = EPS Growth Rate would have indicated a normal P/E of 50.6.
This is important, because clearly Mr. Market is telling us that it feels the risk of investing in this high-growth company is too high to carry such a high theoretical fair valuation. Nevertheless, the slope of the dark blue line is 50.6% and in alignment with the earnings growth rate, therefore, shareholders of Priceline.com have been rewarded with annualized capital appreciation in excess of 50%.
Discovery Communications Inc. (NASDAQ:DISCA)
Discovery Communications Inc., a nonfiction media company, provides content across multiple distribution platforms, including digital distribution arrangements worldwide.
I offer Discovery Communications Inc. as a second example of a hyper-fast growth company that historically trades at a normal P/E ratio that is less than its earnings growth rate. The P/E = Earnings Growth formula was made famous by the venerable Peter Lynch and based on my own anecdotal research, works reasonably well for most true growth stocks.
However, once earnings growth exceeds 20% per annum there is a tendency for the normal P/E ratio applied by the market to be at a discount to very high earnings growth. Nevertheless, the slope of the normal P/E ratio will equate to the company's earnings growth rate and in turn with valuation in alignment, generate capital appreciation returns consistent with earnings growth. Therefore, note that Discovery Communications Inc. has grown earnings at 39.4% per annum, but has tended to trade at a normal P/E ratio of 21.4. However, this is not always the case as we will see with our next example.
Catamaran Corporation (NASDAQ:CTRX)
Catamaran Corporation provides pharmacy benefit management (PBM) services and healthcare information technology (HCIT) solutions to the healthcare benefit management industry. The company conducts its business primarily in the United States, with some additional business in Canada.
Catamaran Corporation has grown earnings at the extraordinary rate of 33.5% since its public debut in June of 2006. Perhaps it's attributable to the company's low debt to capital ratio, or perhaps it's attributable to powerful demographic forces indicating a high-growth opportunity for its industry that have motivated the market to normally capitalize this company's earnings at or above its earnings growth rate achievement. But regardless of the reasons, what is most important is that investors be aware of how the market normally capitalizes any given company.
Acknowledging the Potential for a Slowing down of a Hyper-fast Earnings Growth Rate
One of the great risks of investing in growth stocks, especially hyper-fast growth stocks, is the failure to acknowledge the reality that extremely high rates of growth cannot go on forever. Common sense would indicate that there is a limit to how long a company can grow its business at blistering rates. Therefore, the total return oriented growth investor must be continuously vigilant and on the lookout for the inevitable slowing down of high earnings growth rates. Because, when a slower earnings growth rate does inevitably occur, the rational growth investor must adjust their outlooks and act accordingly. To illustrate this more clearly, I offer the following review of Cognizant Technology Solutions Corporation and how, although its earnings growth remains high, it has shifted to lower levels as time marches on.
Cognizant Technology Solutions Corporation (NASDAQ:CTSH)
Cognizant Technology Solutions Corporation provides information technology (IT), consulting, and business process services.
With my first earnings and price correlated graph I review this company over its entire history as a public company starting in June of 1998 to current time. Operating earnings growth has averaged 46.6% per annum. However, a close examination of the graph indicates that since the Great Recession of 2008 stock price has tracked below the theoretical earnings justified valuation (the orange line). The obvious question is why? So let's drill deeper to see if we can find a rational answer.
With the next earnings and price correlated graph, I look at the earnings growth rate of Cognizant Technology Solutions Corporation from the time frame 1999-2004, the early years and high-growth era in this company's history. During this period of time earnings growth averaged 64.7% per annum and stock price tracked that growth nicely.
Since stock price was reasonably in alignment with and tracked earnings growth, capital appreciation of 59.8% per annum correlated closely with historical earnings growth. When you compare these results to what the Standard & Poor's 500 produced over the same time frame, you get a real clear picture of how powerful and profitable investing in a growth stock can be.
On the other hand, if you look at the earnings growth rate of Cognizant Technology Solutions Corporation since 2004, we discover that earnings growth has slowed to averaging 28% per annum. This still classifies as hyper-fast earnings growth, but it is obviously at a much slower rate than the company achieved during its early years. However, the important fact to be gleaned from this analysis is that stock price valuation since 2004 has clearly been reset and has tracked and correlated to this lower rate of earnings growth. Consequently, the annual capital appreciation of 23.4% reflects and correlates with the companies more recent earnings growth rate.
Google Inc. (NASDAQ:GOOG)
Google Inc., a technology company, builds products and provides services to organize the information.
To reinforce this slowing down of earnings growth rate risk, I provide my second example by reviewing perhaps the mother of all growth stocks - Google. Earnings growth has averaged over 32% per annum since inception, but has already slowed down to just above 21% per annum since 2009. Note: The magenta overlay P/E Ratio of 21.8 reflects this slower growth and accompanying price adjustment. This begs the question, how fast a rate can this $380 billion behemoth continue to grow at?
The following reflects the earnings growth rate adjustment since 2009. Notice how price has adapted to the slower growth rate and has tracked earnings very closely.
The answer to the above question is that the consensus of leading analysts expect Google's earnings growth rate to slow down to an average of 17.5% over the next several years. Consequently, investors in this powerful growth story might be wise to adjust their expectations accordingly.
Can You Pay Too Much for Powerful Growth?
In the comment thread on part one of this series a reader who was more interested in total return asked about the high-growth stocks Vipshop Holdings Limited (NYSE:VIPS) and Baidu, Inc (NASDAQ:BIDU). Therefore, I thought it might be interesting to review these two hyper-fast growth stocks, both of which primarily operate in the China market.
Vipshop Holdings Limited
Vipshop Holdings Limited operates as an online discount retailer. The company offers branded products to consumers in China through flash sales on its vipshop.com Website. The company had 26.8 million registered members and approximately 4.9 million cumulative customers and promoted and sold products for approximately 5,800 domestic and international brands, as of December 31, 2012.
This company has only been public since March of 2012 and its stock price has been on a meteoric advance almost since day one. However, it would be arguable at least, that price has advanced far beyond what its current earnings justify. This leads us to the obvious question, what will this company's future earnings and price record look like?
Although there are only 3 analysts forecasting a long-term growth rate of 55.46%, there are approximately 13 analysts forecasting earnings growth for 2014, 2015 and 2016 of 19%, 74% and 52% per annum, respectively. Nevertheless, even such high expectations of future growth would indicate that the stock is currently overvalued. However, one of the most interesting aspects of investing in hyper-fast stocks is that you can achieve significantly high long-term total returns even if you overpay. Of course this assumes that the company does actually achieve the estimated earnings growth. On the other hand, the wise and prudent investor should simultaneously recognize the distinct possibility of very poor short to intermediate term returns as well.
Baidu Inc. operates as a Chinese language Internet search provider. The company operates a website, Baidu.com.
The same principles discussed with the Vipshop Holdings Limited example above would also apply to Baidu Inc. as revealed in the following earnings and price correlated graphs.
However, there is one difference between this company and what we saw with Vipshop Holdings Limited. With a forecast earnings growth rate expected to be higher than its current P/E ratio over the next three years (see highlights at the bottom of the graph), it's arguable at least that Baidu is a more reasonably-valued hyper-fast growth stock. Additionally, prospective investors should be mindful of the associated risks from both of these examples operating primarily in China.
From Total Return to Dividend Growth Status
One of the big points of contention between the dividend growth investor and the total return investor is the idea that high-quality dividend paying stocks don't require being sold in order to generate income. However, perhaps both sides might consider the fact that many non-dividend paying growth stocks eventually morph into dividend paying growth stocks. Consequently, and in theory at least, the investor during the accumulation phase could invest in high-growth stocks that eventually begin paying dividends as they enter the income phase of retirement.
The following two examples, Apple Inc. and Coach, represent high-growth stocks that have recently begun paying a dividend. This is clearly revealed on the F.A.S.T. Graphs™ with the pink line indicating dividends prior to being paid out of earnings, and by the light blue shaded area on the graph indicating the additional income component of total return that dividends provide. The additional income contribution can also be seen by examining the associated performance reports with the dividend cash flow table.
Apple Inc (NASDAQ:AAPL)
Apple Inc. designs, manufactures, and markets mobile communication and media devices, personal computers, and portable digital music players. The company also sells various related software, services, peripherals, networking solutions, and third-party digital content and applications.
Coach Inc (COH)
Coach, Inc. engages in the design and marketing of accessories and gifts in the United States and internationally. The company's primary product offerings, manufactured by third-party suppliers, include women's and men's bags, accessories, business cases, footwear, wearables, jewelry, sunwear, travel bags, watches and fragrance.
Special Addendum: Select High-Growth Total Return Research Candidates
In special consideration of those readers interested in investing in growth stocks for high total return, I offer the following growth stock research candidates. As a caution, I'm not suggesting that every one of these names will turn out to be great long-term investments, nor am I suggesting that they are all reasonably valued today. Instead, I offer this as a group of companies that meet my 15% future growth criteria qualifying them as growth stocks, with each requiring further due diligence before investing.
Summary and Conclusions
Hopefully, this article has provided both total return oriented investors, and even dividend growth investors, additional insights into the benefits that investing in growth stocks can deliver. Again, I will turn to one of Peter Lynch's 20 Golden Rules for further insight:
"Time is on your side when you own shares of superior companies. You can afford to be patient - even if you missed Wal-Mart in the first five years, it was a great stock to own in the next five years. Time is against you when you own options."
However, I also hope that this article revealed some of the major risks and pitfalls associated with this more aggressive type of common stock. Importantly, the reader should also be aware that I only scratched the surface of the potential risks that investing in this high-growth stock category can have. Consequently, I end with the prudent caution - "Caveat Emptor" (let the buyer beware).
Disclosure: Long DECK, CTSH, GOOG, AAPL at the time of writing.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.
Disclosure: I am long DECK, CTSH, GOOG, AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.