Magnify Your Profits From the Bounce

Tuesday's 900-point spike in the Dow Jones Industrial Average is most likely just another head fake in the epic back-and-forth struggle gripping the market. But those of us who still have faith that stocks will eventually head higher in a more lasting way are wondering one thing: How can we maximize the gains to come?

Recently, my Foolish colleague Joe Magyer debunked a Wall Street myth that is doubtless responsible for billions of dollars in lost wealth: the well-documented tendency of analysts to grossly overestimate the future growth of the companies they follow and consequently come up with overblown target prices for stocks.

Actually, it's more than a myth
That tendency to exaggerate is an innate bit of human nature that's well-known to psychologists and economists. We should expect better of analysts who are paid huge salaries to predict the future, but most people can't avoid this form of impact bias. They expect happy days to linger longer than they will. They tend to extrapolate the future as an extension of the present. In good times, that means they see current high growth rates lasting longer than is likely. And the further out they look, the more that sunny optimism compounds their error.

Flip those binoculars around, my friends. The magic of compounding works both ways.

Pessimism about the current state of the economy also gets worked into stock prices, whether formally by analysts or emotionally by investors who simply flee from all of their stocks and drive prices down. By selling today, those investors believe that the future will be worse than the present. Growth will slow or turn to contraction. Earnings will slip or turn to losses. And those companies that were once growing the fastest will, through the compounding effect of pessimism, see their future outlooks -- and their stock prices -- take the hardest hit.

To see what I mean, just plug some numbers into a simplified discounted cash flow analysis. Let's take two companies, each with $1 million in free cash flow and 1 million shares outstanding. We'll assume that 10 years from now, each will mature to a steady rate of 3% growth. But in the interim, one company is expected to grow cash flow at 20% annually, while the other is expected to do so at 8%.

Here are their intrinsic values, assuming a 10% discount rate:

Now let's cut both growth estimates by half. Here's what happens:

The slower-growing company loses almost 26% off its intrinsic value. But the faster-growing company loses twice that much, more than 52%. We've compounded our pessimistic assumption about growth across the next decade, and as a result, the faster-growing company sees its valuation come down twice as quickly.

In fact, that pretty accurately reflects some of what we're seeing in the market today:

If you believe that investors today are being too pessimistic about the future, you should expect stock prices to eventually rise. It's also reasonable to expect that the fastest growers will rise the most as sunnier expectations about future growth are compounded. Kraft has risen 11% off its 52-week low set Oct. 10. VMWare has climbed by more than 50% from last Friday's lows.

This isn't just a matter of assuming we'll see an equal-but-opposite reaction to what has unfolded over the past few months, during which former growth darlings such as VMWare or Infinera (NASDAQ:INFN) have taken an outsized beating. Likely growth rates for many companies have come down as the economy further slows. Some companies facing capital shortages may simply not be able to survive, where once they could have raised the money necessary to continue and even succeed -- just look at the recent bloodbath in the biotech sector.

The Foolish bottom line
In fact, it's best to avoid generalities or broad strategies altogether when it comes to so-called growth stocks. Simply deciding that growth must have its day is a risky strategy. So is buying the stocks that have fallen the farthest, or chasing a high beta.

The truth is, "growth" as broadly defined -- at least for the purposes of index funds -- has been taking a whooping almost this entire century: From May 2000 to the present, the iShares S&P 500 Value Index ETF (NYSE:IVE) is down 10% on a dividend-adjusted basis. The iShares S&P 500 Growth Index (NYSE:IVW) is down 40%. And that gap has actually narrowed since the end of 2006.

But rational analysis can uncover many companies for which reasonable growth expectations have been overly discounted in these dark times. It means looking at one company at a time, which is why a team of Rule Breakers analysts recently traveled to Silicon Valley on an "Innovation Tour." We went looking for the best offerings of the tech sector, and after meeting with company management teams and venture capitalists, we have a few ideas.

Want full access -- for free -- to our trip dispatches? Just click here, enter your email address, and tell us where to send the first dispatch.

Karl Thiel owns shares of Infinera but of no other companies mentioned. The Motley Fool also owns shares of Infinera. Infinera and VMWare are Rule Breakers recommendations. Kraft is an Income Investor selection. The Fool is investors writing for investors.