One of the major risks of investing in fast-growing small companies is projecting how long a heady growth rate will last. Just like in nature, there is an element of friction at work in market economies. Business momentum tends to fade over time, even for the fastest of fast-growers. This fundamental small business reality is a big reason why investing frameworks such as the Foolish 8 system are best used within a relatively short investing time horizon, such as three to five years. While that's still a long time in some investors' minds, it's a wholly different mind set from buying a company with an eye toward holding it forever.
When a fast-grower first starts to show signs of business growth moderation, many small company investors will decide to dump it immediately from their portfolios. But this raises a question: Once a former fast-grower slows down, can its business ever pick up again? Can fast-growth be revived again and again, or is it just a fleeting stage in a company's lifecycle?
Most likely, it depends on the company in question, as every investing situation is unique. But there is the possibility that small companies can return to past growth rates, so long as there is an identifiable driver to lead the growth resurgence. Such drivers are referred to in investing lingo as "catalysts," a term lifted from the natural sciences and applied today to the business world.
The trick about looking for catalysts in stocks is that they are easy to identify in hindsight but can be difficult to isolate in the here and now. Without a doubt, a new management team, a new strategic direction, or a new patent or production process can act as a catalyst for jumpstarting business growth. However, once the catalyst becomes apparent and sets a specific business reaction in motion, the company's stock has more often than not already shot toward the stratosphere. So, investing with an eye toward possible future business changes can be a real challenge, although as a strategy it makes a great deal of sense.
Without a real business catalyst for investors to latch onto, a stock can stay mired at the same price level for what can seem like an eternity. A good investing friend of mine likes to say that a cheap price alone is a good enough catalyst for most stocks. But I don't fully agree with that opinion, especially with regards to small-caps. In this area, cheap stocks can stay cheap for a long, long time. Again, it's all a matter of your individual time horizon.
One company that could be interesting if a catalyst ever presents itself is the restaurant operator Steak n Shake Co. (NYSE: SNS), which is the new name for the company that used to be known as Consolidated Products. The company was a favorite of a former Fool writer, who wrote a terrific overview of the business back in 1999. The old Consolidated Products was a great fast-growth small cap in the mid-1990s, when the Steak n Shake concept was in full expansion mode. From 1993 to 1997, the company was growing its unit base at about a 20% annual clip, which translated into annual EPS growth in the mid-20% range.
Steak n Shake's high-growth days started to fade a few years ago, when a tight labor market made it harder for the company to keep a handle on labor costs. By the looks of the firm's fiscal Q2 earnings release yesterday, the problem is persisting. For the first half of the current fiscal year, restaurant operating costs equaled 49.8% of total revenues, compared to 43.9% toward the end of its growth run in fiscal 1997. This is a meaningful jump, particularly for a restaurant company that operates with pre-tax margins in just the 10% neighborhood during even the best of times.
As a result of the change in the economic environment, the company has ratcheted down its expansion growth rate and has focused instead on basic restaurant blocking and tackling. The shift appears to be paying off, as total revenues climbed 15% in Q2 and same-store sales rose 6% after a flat result in Q1. For the full year, Steak n Shake is projecting 19% EPS growth, a major improvement from the bumpy EPS ride over the past few years.
The lingering question is, "What is the catalyst that can sustain a 20% growth rate for more than a year or so?" Last decade, the big catalyst for the company's business growth was its unit expansion rate. However, in 2001 the company intends to increase its unit base by only 7% to 8%. Most of the EPS growth this year is seen coming from revenue growth at existing units and tighter operating cost controls. Management is smart to be focusing on maintaining a high-quality product and keeping existing customers happy right now. But long-time shareholders are suffering with the company's stock price back at 1996-1997 levels.
Steak n Shake illustrates the need for a small company to have a recognizable catalyst to sustain high rates of growth and deliver the high future returns that get many small cap investors' hearts beating faster. Right now, this appears to be one of the main elements holding Steak n Shake's share price back. The concept definitely works, the management team is solid, and I'll vouch for the quality of the product. (Especially the Bacon 'n Cheese Double Steakburger -- YUM!) With a little help from the right business catalyst, this small company could return to its previous fast-growing ways.
Brian Graney can't wait for his next trip to Orlando, Florida so he can eat again at his favorite Steak n Shake. At the time of publishing, Brian did not hold shares of any companies mentioned above. The Motley Fool is investors writing for investors.