SIVY ON STOCKS from money.com
October 9, 2000
Investing for
growth
Every portfolio needs a healthy dose of growth. Finding it is easy
-- here's how to not overpay for it.
By Michael Sivy
Stock prices
follow earnings. In fact, over a long stretch of time, rising corporate profits
are the only force that can keep share prices moving higher. Investors may pay
up for the earnings of a popular company, which boosts the price/earnings ratio.
But while rising P/Es can lift stocks for a few years, there's a limit to how
high they can go.
As a result, growth investing, or seeking out companies
with above-average earnings growth, should be a key part of your strategy. It's
also the simplest approach to the stock market.
Historically, the S&P 500
has returned around 12% a year. So if you can find a company with earnings
growing faster than that, the stock will eventually outpace the market --
provided its earnings come through as expected and that the stock was fairly
priced to begin with.
What's a fair price? P/E ratios and price/cash-flow
ratios are the most common measures of how expensive a stock is. A lot of
factors influence P/Es, including interest rates, the company's track record and
the industry it's in. But one reliable tool is to compare a company's P/E to its
projected earnings growth. Ideally, you don't want to buy at a P/E much more
than the growth rate, and in a normal stock market, there are plenty of such
bargains. But over the past five years, they have become harder and harder to
find.
Today most high-quality companies with double-digit earnings growth
have P/Es that are at least 1.5 times their growth rate (that is a PEG of
1.50, which is too high for a start. You should be thinking of selling out of
many companies between 1.50 and 2.00). For example, shares of a company
with 14% earnings growth would trade at a P/E of 21 or higher. If you're
interested in the most popular growth stocks, you may have to grit your teeth
and pay even more -- P/Es that are double the growth rates, for instance. But
you have to draw the line somewhere. Hold off on buying stocks that are trading
at P/Es more than 2.5 times their growth rates, no matter how good the companies
are. When a stock with a P/E that high stumbles, its shares drop like a
rock.
If you can get a stock at a PEG of 0.6 Example PE of 12 and a growth rate
of 20% for each of the next two years, go for it.Remember Sivy is talking about
the US market with an average PE that I believe is over 20. NZ. Australia and UK
are below these levels.
Some of your best bargains will be found at the opposite end of the spectrum,
with companies that have earnings growth around 12%. With those stocks you may
want to add in the dividend yield to get a total return estimate. For instance,
a stock with 11% growth and a 3% yield might really be able to return a total of
14%. Getting a stock like that for a P/E below 20 could be a great deal.
For
some stocks -- particularly industrial companies -- cash flow provides another
reliable benchmark for value. You can find the amount of cash a company
generates each year listed in brokerage reports or other standard research
sources, such as the Value Line Investment Survey (some firms also report
EBITDA, a similar measure). When a stock is selling at less than 10 times cash
flow per share, it may well be a compelling value.
Whichever spot on the
growth spectrum you favor, remember that the key to long-term profits is
consistency. Companies with above-average growth that you can buy and hold
indefinitely are the most valuable additions to your portfolio. Since
commissions and other fees are a significant drag on returns for individual
investors, the less often you buy and sell, the less you have to think about
expenses. In addition, if you don't trade much, you won't have to worry about
mistakes in your timing.
See IRG research reports
