As 2023 approaches, most investors likely want to put 2022 behind them. Amid massive stock declines and high inflation, some investors worry that the market has entered a period of stagnation comparable to the 1966 to 1983 time frame when the Dow Jones Industrial Average could not consistently stay above 1,000.
That sentiment may or may not come to pass. However, under such conditions, a few growth stocks still produced outsize returns. By learning to identify such stocks early, investors could earn considerable gains, even when the broader indexes do not.
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Growth in a stagnant market
Growth investors could have an unexpected ally in the P/E ratio. Between the mid-1970s and early 1980s, the average S&P 500 stock sold at a P/E ratio of less than 10. Admittedly, such valuations may not seem to help investors in a stagnant market, especially considering that the average S&P 500 P/E ratio is about 20.
Nonetheless, investors should remember that a P/E ratio is a stock's price divided by its earnings. That means if earnings climb and a stock's price stays the same, that ratio will fall. At an earnings growth rate of 50%, it would take a P/E ratio from 20 to just 6 if the stock's price were to stay the same over three years.
| Effects of Earnings Growth on a P/E Ratio, Assuming Stable Stock Prices | |||
|---|---|---|---|
| Year | Price | Earnings Per Share (Assuming 50% Growth) | P/E Ratio |
| 0 | $200 | $10 | 20.0 |
| 1 | $200 | $15 | 13.3 |
| 2 | $200 | $22.50 | 8.9 |
| 3 | $200 | $33.75 | 5.9 |
Chart by author.
In the short term, trader emotions could stay negative, and investors might ignore such a growth rate for a time. However, famed investor Warren Buffett's mentor, Benjamin Graham, described the market as a "voting machine" in the short term and a "weighing machine" in the long term.
As those valuations come down, at some point, the "weight" of the stock will probably receive due consideration. At some point, investment gains become a near certainty since high growth at a low valuation is attractive in almost any market.
Leveraging innovation
Moreover, such increases can occur because of one seemingly enduring phenomenon in American business -- innovation-led growth. Even in the 1970s, investors can find numerous examples of this. Enterprises such as Intel and Southwest Airlines experienced massive growth as they revolutionized their industries.
Also, during the 1970s, investors began to pay more attention to an Omaha-based investor named Warren Buffett. As late as 1976, they could buy his Berkshire Hathaway A shares for under $100 per share, a stock that rose to about $425 per share by 1980. Today, A shares sell for about $450,000 per share.
However, the easiest of these to understand may be the rise of Walmart. At the time of its 1970 initial public offering (IPO), it was a small-town retailer with 38 stores in the south-central U.S. Over time, its then-innovative small-town department stores and IT-driven supply chains drew customers and investors alike.
Between the IPO and the fourth stock split in November 1980, the stock would rise by over 48-fold, well above the 29% gain in the Dow during that time frame. That set the stage for accelerated growth in subsequent decades. Although Walmart's high-growth days are probably over, its stock has increased by nearly 18,000-fold since its inception.
Benefitting from history
Investors should study history not to buy the growth names of the past, but to discover where to find growth in the future. Innovation has not stopped, and new ideas continue to drive the creation of new companies. Artificial intelligence, DNA sequencing, energy storage, robotics, and blockchain are some of the industries that could spawn such growth.
Whether a new bull market is coming or not, investors should hone their investing skills to find these emerging industry leaders. If investors think strategically, stay on top of financials, and understand how competitive advantages evolve, they can prosper regardless of the S&P 500's near-term direction.
