Finding Great Growth Stories

In a recent article titled "70 Times Better Than the Next Microsoft," I highlighted some data from Moneychimp.com regarding the superior performance of small-cap value stocks over small-cap growth stocks in the last 79 years:

To make a long story short, investors habitually overestimate companies' future growth. They pay too much for high growth rates that never materialize. Why do investors make that mistake, and how can we Fools avoid it?

Here's one simple answer: Many growth investors are surprised, even stunned, to learn that companies grow earnings per share by only about 6% to 7% per year on average, including inflation. Without inflation, EPS growth averaged 2%-3% per year over the last 50 years.

But Wall Street analysts' frequently lofty projections for future growth, even for large, established companies, tend to amount to 10% or 15% a year. They often go as high as 25% or 30%. A lot of investors end up paying too much in expectation of such heady growth.

Yet companies as a group cannot grow their earnings per share that quickly -- not if they pay dividends, buy back shares, or will be limited in any way by the growth of the economy, which also tends to expand at somewhere around 3%-4% a year.

Show me the math
Companies' historical EPS growth is well-documented and well-understood, if not necessarily widely distributed. The commonly understood equation for sustainable earnings growth is given as:

Return on Equity (ROE) * retention rate (or 1- payout rate)

Let's give an example using the historical norms. In his recently published essay "Clear Thinking about Share Repurchases," Michael Mauboussin states:

". over the last 50 years, the payout ratio (heavily determined by dividends until the mid-1980s) has been just over 50% [with] ROE in the 12% to 13% range, yielding nominal earnings growth of 6% to 7%. Inflation during that same period averaged 3% to 4%."

Jeremy Siegel's data in The Future for Investors shows the same low earnings-per-share growth noted by Mauboussin.

What's true on the macro level is equally true on the micro level. Over time, a company's EPS growth will be limited by the returns it can generate on its equity, and how much of that equity it retains.

Where to look for sustainable growth?
True earnings growth stories do exist, and when you find a legitimate one at the right price, it can do wonders for your portfolio.

As Motley Fool Hidden Gems chief Tom Gardner has written elsewhere -- borrowing from the lifetime work of Peter Lynch -- monster stock market winners come from identifying companies with:

• 20%-25% growth rates ...
• Sustainability for five years or more ...
• Achieving it without significant share dilution, and ...
• Ability to be acquired at a fair price.

But that's easier said than done, as shown by the cumulative returns that growth investors have enjoyed over the past three-quarters of a decade. Fools should always consider a company capable of 20%-or-more earnings growth as a rarity at best.

When seeking companies with that kind of sustainable growth, you should first run some numbers to see what they've accomplished in the past. I searched for companies with ROEs between 20 and 35 for each of the past four years, capitalized above $200 million, with payout ratios of less than 40%. I found only about 40 companies listed on the U.S. markets, of which seven particularly interested me:

A little knowledge is a dangerous thing
There's more to determining a company's future growth and profitability than simply looking to the past. Nonetheless, these companies have demonstrated a previous ability to grow earnings far faster than the market average.

However, in many of the cases above, there's a quick and obvious reason why the company's sustainable future growth won't match its past ROE retention rate. For example, the chart shows that Harley-Davidson isn't paying much of a dividend, but it isn't currently reinvesting its earnings in its business, either. The motorcycle manufacturer is more focused on returning money to stockholders through share buybacks. Last year, it spent more money than it made paying dividends and buying back shares. Unless it resumes reinvesting profits in its business, it likely won't enjoy its previous high growth rates. It can keep growing earnings per share by reducing the share count, but it won't increase near-term net income by anything approaching 24% a year.

On the whole, smaller companies have a greater chance of maintaining sustainable growth stories than larger ones. It's easier to reinvest a few million dollars each year in your business than a few billion. Just don't assume that projections of 20% growth in the future will come as easily as the Wall Street Wise seem to think.

Over the past two and a half years, the selections from our Motley Fool Hidden Gems newsletter are up a cumulative 39%, compared with the market's 13% returns. See for yourself, and discover Tom Gardner's latest small-cap picks, with a free 30-day guest pass.

Bill Barker writes a daily column for Hidden Gems. He owns shares of Harley-Davidson but holds no financial position in any other company mentioned in this article. Marine Products is a Hidden Gems pick, while Bed Bath & Beyond and Best Buy are alliteration-heavy Motley Fool Stock Advisor picks. The Fool has a disclosure policy.