The Danger Of Growth Investing

by: Tim McAleenan Jr.

Considering that Benjamin Graham believed that finding a built-in margin of safety was the most important element of earning superior returns on a risk-adjusted basis, it probably comes as no surprise that Mr. Graham did not become an investor in high-growth stocks. In fact, he dedicated a large portion of his famous investing treatise, "The Intelligent Investor," to articulating what he called "the danger of the growth-stock program." On page 517 of the "The Intelligent Investor" edited by Jason Zwieg, Graham explains exactly what he considers dangerous about a growth stock investing strategy:

"The danger in a growth stock program lies precisely here: For such favored issues the market has a tendency to set prices that will not be adequately protected by a conservative projection of future earnings. (It is a basic rule of prudent investment that all estimates, when they differ from past performance, must err at least slightly on the side of understatement.) The margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, nonexistent at some still higher price. If, as we suggest, the average market level of most growth stocks is too high to provide an adequate margin of safety for the buyer, then a simple technique of diversified buying in this field may not work out satisfactorily. A special degree of foresight and judgment will be needed, in order that wise individual selections may overcome the hazards inherent in the customary market level of such issues as a whole."

Take a company like Amazon (AMZN), for instance. Graham would have no idea how to find a margin of safety in the price of the stock. Since 2002, the P/E ratio of the company has ranged from a low of 42.8 to a high of 104.6, with most years (2003-2005, 2008, 2010) displaying a P/E in the 50 to 60 range. Graham most likely would not be able to tell you at which point the stock became cheap-is it overvalued at 50x earnings, 60x earnings, or 70x earnings? Graham points out that high growth stocks take on this nebulous quality that makes it very difficult for investors to find a proper valuation.

After all, Amazon has done quite well over certain periods of time. Earnings per share doubled from $0.40 per share in 2003 to $0.82 per share in 2004, and they again doubled from $1.12 in 2007 to $2.04 in 2009. And certainly, the skyrocketing stock price could have made any man rich several times over. The stock hit a low of $5.50 in 2001, and based on the current price of $178, any investor could have turned a $10,000 investment at that time into $323,000 today. So to be sure, Graham never claimed that high-growth stocks can't treat investors well.

But still, Graham was particular in outlining the kind of risk that faces investors in fast-growers like Amazon that is simply not present in stalwarts like Coca-Cola (KO), Exxon-Mobil (XOM), Colgate-Palmolive (CL), or Kimberly-Clark (KMB). And that is: the difficulty in finding a margin of safety with high-flyer stocks. The reason for desiring a margin of safety, to quote Graham, is "to absorb the effect of miscalculations or worse than average luck." When there is no margin of safety built into the stock price, the investor diminishes his ability to see the stock whether adverse developments and still come out ahead.

Value Line predicts that Amazon will be earning $9 per share by the end of 2016, which is a notable increase relative to the company's trailing twelve month earnings of $1.90. If Value Line is right, folks who purchase Amazon at $178 per share could do very well with their investment. But as investors in Netflix (NFLX) who have seen shares fall from $304 in July to $73 today could tell you, sometimes you might want to make an investment that leaves room for "worse than average luck," as Graham would put it.

Graham never claimed that you can't make a lot of money with high-growth stocks. But he would tell you that if you bought General Electric (GE) at $10 per share or Wells Fargo (WFC) at $12 during the financial crisis, a lot of things can go wrong and you could still make a lot of money on your investments. When you enter the realm of the Amazons of the world where you're expecting 20% to 30% annual growth each year, you will probably do very well if that happens, but the danger of paying 50-60x earnings for a company is that the margin of safety disappears. Before you make an investment in a high-flyer, you should ask yourself the question: By paying this price, what happens if I have "worse than average luck"?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.