Among the business-specific screens used by the Foolish 8 system for identifying good small companies is a minimum level for year-on-year sales and earnings growth. For our purposes, the minimum level we would like to see is 25% for both top-line and bottom-line growth. Like the $500 million maximum cut-off for annual revenues, there is nothing inherently special about this 25% figure. It's just another number -- albeit a fairly high number as far as growth rates are concerned.
There are both direct and indirect effects from setting the revenue and earnings growth bar at such a high level from the outset. In terms of direct results, requiring a 25% sales and earnings growth rate substantially narrows the field as far as prospective investments are concerned. Screening at Quicken.com indicates that fewer than 10% of all U.S. publicly traded stocks are currently jumping over growth hurdles this high, and in fact the final number is actually closer to 5%. In more everyday, household terms, what you get after using this filter is some pretty high-test coffee.
As a way for limiting the field of small company investment candidates, the 25% earnings and sales growth standard is one of the most effective of all the Foolish 8 screens. But an indirect consequence of the screen's effectiveness and high-growth emphasis is a general tendency to want to brand the Foolish 8 system as just another way of finding small cap growth stocks. This is unfortunate from at least two different perspectives.
For starters, the first element of that phrase -- the small cap part -- is not really desirable due to semantics, as has already been discussed. Here's the default explanation against all things small cap: The purpose of the Foolish 8 is to identify good small COMPANIES, regardless of what market capitalization decile they may fall into. However, the growth part of the small cap growth stock characterization is not really up for dispute. Insert a 25% annual revenue and earnings growth screen into your system, and a list of fast-growing companies is exactly what you will end up with.
Growth is not altogether a bad thing. But a singular emphasis on growth stocks rather than growth companies is not so wondrous a thing, which is the second failing of the small-cap growth stock label. It may sound counterintuitive at first, but an investor's primary emphasis should not be on stocks, it should be on businesses.
Talk too much about growth stocks instead of growth companies and pretty soon you'll find yourself stuck with the default label of a growth investor. Traditionally, such pigeonholing automatically pits you in some kind of philosophical cage match with so-called value investors. Of course, this ideological showdown may make some sense if your worldview is purely stock-focused. But to a business-focused investor, the growth stock vs. value stock debate is just a bunch of Wise hooey, as fund manager Bill Miller has pointed out with the following thoughts:
"There is no theoretical difference between value and growth; the value of any investment is the present value of the future free cash flows of the business... The terms are mainly used by consultants to allow them to carve the world of money managers up for clients. They represent characteristics of stocks, not of businesses."
Sounds a lot like the equally questionable practice of breaking up companies into separate small cap and large cap camps, doesn't it? If you treat stocks as share ownership interests in companies and not pieces of paper to be traded around, such debates can be seen as the wastes of time that they actually are. That's cool, because then you can spend more time on what really counts -- analyzing companies.
The bottom line is that small company investors, like all investors, should be trying to determine a company's value. True, items such as sales and earnings growth rates are two factors that go into a valuation analysis. But they are not the only factors, and nor is the growth rate the end-all, be-all determinant of a company's underlying value. The amount of capital that needs to be invested in a business to sustain its growth rate and the quality of a firm's earnings are also important factors to consider prior to arriving at a thoughtful value determination.
However, such company-specific, qualitative elements of value cannot be fully expressed by traditional quantitative valuation screens, such as price-to-earnings ratios, price-to-sales ratios, or price-to-anything-else ratios. That's why such ratios -- which are oftentimes little more than valuation shortcuts to nowhere -- are left out of the Foolish 8 system. Valuation must be deduced through objective analysis, which is the next logical step after the Foolish 8 business and market screening process.
Still, earnings and sales growth are legitimate factors for small company investors to consider. But throughout the stock selection process, it's important to understand what growth and value are and what they are not. Ignoring the long-standing growth stock vs. value stock debate is a good start. Ideally, small cap investors should be looking for "growing value." By adopting and maintaining a company-based approach to small company investing, it's easier to see how the analytical pursuits of focusing on underlying business value and looking for high-growth rates are not necessarily distinct or mutually exclusive.
[Motley Fool Research's Industry Focus 2001 features more on Foolish 8 small-cap stocks.]
