There's a bunch of rules of thumb and guidelines to remember while you're evaluating growth investments. It's easy to get lost in the weeds when you're squinting at balance sheets and trying to interpret complicated business models.
But it'll improve your investing craft immensely if you can step back and simply appreciate some of the most obvious -- and most overlooked -- truths about growth stocks. Let's take a moment and think about three in particular.
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1. Management's plans aren't destined to become reality
The most important obvious truth about growth-phase businesses is that a company's leaders can be wrong.
Plans can be implemented poorly or incompletely, and external events can throw a wrench into the most carefully calculated maneuvers. The more ambitious the proposed plan, the more evidence that investors should look for when it comes to judging management's performance.
Of course, those risks rarely get mentioned by CEOs and others when they're pitching the company's pivot or its ambitions to penetrate a given market. Nor are investors guaranteed to get a mea culpa or an accounting of what went wrong if a plan doesn't come to fruition within the target timeframe. Conducting that task is up to you, and it pays to do it.
One of the easiest ways to evaluate management's track record is to look at a quarterly earnings report from a year or two in the past, and compare their comments to those in a more current report. Especially for rapidly expanding companies, you may find that plans to meet critical benchmarks for factors like profitability are perpetually on the horizon from year to year.
That doesn't mean you should dump the stock or refuse to invest in it. But it does mean that you should be aware that when a CEO sounds ultra-confident about the future, they are trying to sell the idea of the company to you and other investors.
If the company consistently delivers to management's spec as communicated to shareholders, it's a major (and I want to emphasize major) point in favor of making an investment. But when things are evolving rapidly, especially with younger businesses, it's reasonable to expect an imperfect lineup between expectations and what's actually delivered. Just make sure that there's ample progress toward the loftier targets before buying.
2. Controversies are not always company-threatening financial risks
Often, controversial issues lead investors to fear that a company could disappear. It's not unusual for those fears to be overblown.
For instance, Johnson & Johnson (JNJ -0.69%) is facing lawsuits alleging that its talc powder products were contaminated with asbestos for decades and caused cancer. That has led the healthcare giant to seek to limit its liability in a variety of ways, including some corporate restructuring moves and discussions of potential settlements.
Many fear that if J&J can't get a favorable resolution, then it could be catastrophic for the company. Yet even if things turn out badly and Johnson & Johnson ends up being on the hook for billions of dollars spread out in payments over many years, it still isn't likely to do a huge amount of damage to the stock price. The healthcare giant simply has the financial resources to deal with most likely outcomes.
While J&J isn't a growth stock, the episode is an educational one that certainly applies to growth-phase companies.
The obvious truth here is that controversies and events that people see as being "bad PR" aren't necessarily financially impactful for shareholders or for investors considering a purchase of a stock. Unless a controversy implies a new cost that's significant relative to the company's resources, it's not financially relevant.
Anyone can prompt a controversy by saying something controversial, but without an economic impact, it's just noise. It's easy to forget the above because controversies tend to be emotionally salient, and the fire of outrage tends to obscure clear thinking.
The market weighs the prospects of a competitor becoming either more or less valuable in the future than it is today. Chatter about a company's lack of ethics does not factor into that calculation, even if it's accurate. So keep in mind that a controversy isn't always a reason to dump your shares of a stock, and, depending on the situation, it might not be a barrier to buying a stock either.
3. Short-term economic and market conditions might tank stock prices, but they don't have to destroy long-term value
The last obvious truth is that the economy can cause a company's earnings to falter or boom, and the market can cause a company's stock to rise or fall, but neither the economy nor the market can destroy a company's value. Here's why.
Many companies are cyclical in nature. During good times, their shares often look to be bargain-priced, with huge earnings relative to the stock price. However, those boom times always give way to cyclical downturns, and when that happens, the stock can plunge.
Those companies can't control the cyclical forces that are at play in their respective industries. All they can control are the resources they have, the processes they use to operate, and the staff they have to implement those processes to properly manipulate their resources for gain.
It makes sense to adapt corporate systems to compensate for or to take advantage of external factors like the market or the economy. But in the long term, external headwinds are likely to abate, and competitors with the best systems for generating value will tend to come out ahead. So focus less on the quarter-to-quarter struggles that a company faces, and more on whether it's succeeding in creating a system that'll outperform its peers in the future.
