Friday, March 16, 2012

Thinking rationally about growth


It is not uncommon for a fast-growing company to get overvalued by the market. And as we all know, investing in overvalued stocks is never a good recipe for attractive long-term returns. Sure, growth is great, but how do we take a company’s revenue and profit growth rate into account when valuing that company’s stock?  This article will give you my take on valuing growth companies:

I usually treat growth as a bonus, and value a growth company based on its current profitability. In other words, I would value a growth company just like how I would value any other company. However, there is value in the company’s growth, and I will account for that value by requiring a smaller discount to intrinsic value before investing in the stock (Benjamin Graham’s margin of safety concept states that stocks should be bought at a discount to their intrinsic value to reduce risk). One of the best ways to reduce risks is to earn more money; that’s my rationale for requiring a smaller discount to intrinsic value if the company is growing earnings at a good rate.

It’s only in the case of a very attractive company (both high growth and excellent returns on equity) that I might consider paying a higher valuation than what the company’s current profitability would suggest as appropriate. In this type of situations, I will look to the price/earnings to growth ratio that Peter Lynch popularized. The PEG ratio is basically the P/E ratio divided by the growth rate. As a general rule, you only invest in the stock if its PEG ratio is below 1. Example of the PEG ratio in action: If company Awesome Inc. has a P/E ratio of 15 and an estimated annual growth rate of 20%, then its PEG ratio would be 0.75 (15/20 = 0.75) which seems pretty good.

I don’t project growth into the future by plugging in a growth component when discounting future cash flows because you need both expert knowledge of the industry and the company to make any reliable estimates of growth. Even then I’m doubtful that someone can accurately predict the company’s growth rate far out into the future (you need to have a timeframe of at least 10 years if you want to be a serious long-term investor). For people without good knowledge of the company and the industry, adding a growth component when discounting future cash flows is dangerous in the sense that they can drastically overvalue the company.

It’s important to remember this point on growth made by Warren Buffett that growth is only good if the company can achieve good returns on capital. There’s a long-term adverse impact on shareholders’ wealth if the company retain earnings and load up on debt to pursue growth opportunities that yield subpar returns. So, when thinking about a company’s growth rate, don’t forget to look at the company’s return on equity and whether or not it has a durable competitive advantage (at the end of the day, a company can only sustain good returns on capital if it has a durable competitive advantage).

If you have any questions or have anything that you would like to share, please feel free to comment or send me a private message.  Thank you for reading, and may you always sustain good returns on your portfolio. Take care.

Saturday, March 3, 2012

Classroom Investing Myth 1: Risk-free asset


A lot of the finance and investing theories taught in the universities today are simply nonsense. If anyone just took some time to rationally think about classroom stuff like risk-free asset, dividend growth model, beta, and efficient markets, they would come to the conclusion that those ideas are just plain wrong and financially dangerous if applied in reality.

In the first part of the “Classroom Investing Myths” series, I will be looking into the legend of the risk-free asset. Side note: I don’t know how many parts this series will have as it is sort of me just writing an article whenever a bogus investing theory comes to my mind.

Just flip through any finance textbook, and chances are that you would find something about government issued securities being risk-free assets. Nothing can be further from the truth. In fact, you will probably lose money in the long-term if you invest in U.S. treasury securities at current low yields. You might not lose money in nominal terms, but you will almost certainly lose purchasing power (According to this article at InflationData.com, inflation has historically averaged around 3.4% annually; the current 10-year treasury yield is only about 2%). This defeats the purpose of investing as defined by Warren Buffett in his article in CNN Money (You can read Buffett’s article here). Here’s how Buffett defines investing: “At Berkshire Hathaway (BRKA) we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power -- after taxes have been paid on nominal gains -- in the future.”   

You can’t even make a case that you’re investing in treasury securities to preserve wealth. If inflation outpaces an asset’s yield, your wealth will be destroyed not preserved. So what if you have slightly more money in nominal terms after the investment matures. If you can’t purchase as much stuff after making the investment as compared to before, then by definition you’re worse off.

Take the 10-year treasury yield for example, you will lose 1.4% in real terms every year if inflation just went back up to its historical average (and who is to say that inflation won’t go significantly above the historical average for a sustained period of time). Not only that, you won’t be compensated for risks such as the large deficits and the humongous amount of debt of the U.S. government which will lead to the printing of money which in turn will result in higher inflation. In the case of Greece, investors had to take a “voluntary” hair cut on their Greek government debt holdings leading to both a nominal and real loss.

It’s a fallacy that there are riskless investments. Those people planning to park their money in U.S. treasury securities for the long- term because they’re afraid of risks seriously need to reevaluate their decision. You might face risks investing in a bond fund, mutual funds, individual stocks and other assets, but it sure beats the slow painful decline in your purchasing power that you will almost certainly experience if you just held on to treasury securities at their current yields for the long-term. To invest in assets like stocks, real estate, or any asset for the matter, you of course need to know what you’re doing or you might just end up in a much worse position than if you invested in treasury securities (you might still underperform if you knew what you were doing, but odds are you will come up on top).

If you have any questions or have anything that you would like to add, please feel free to comment or send me a private message. Thank you for reading, and may you always sustain good returns on your portfolio. Take care.