Growth is a thing of beauty. But just as Scarlett Johansson on TV distracts me from my dog chewing up a pair of socks, growth causes many investors to lose track of what else is going on with an investment. Most often, we overlook whether the underlying stock price is reasonable, given the relevant growth rate.
I realize that not all investors are so easily distracted. For many, focusing on growth while ignoring value seems like heresy. But a large number of investors are clearly blinded by sky-high growth rates. For example, each time I question whether the price of a growth stock such as Google
Two sides of the same coin
That's not to say I'm disinterested in fast-growing companies. I want a company to display solid growth as much as the next guy. But I absolutely do not want to pay more for that growth than it's worth. That's the rub. You can't separate growth from value, because growth is a part of the equation for determining value.
In the stock market, such relationships are common. Companies' shares will trade sideways for years, despite double-digit gains in earnings, simply because a higher level of growth was priced into the shares.
The following tables display two sample groups of companies. I found the first group by running a screen for companies with revenue and diluted earnings-per-share growth that beat the S&P's 13.2% compound annual return over the past three years. I then reversed the screen and looked for companies that grew revenues and earnings by less than 13.2%. Surely, companies that are growing earnings faster than 13.2% per year will thump the slow growers, right?
Fast growers
|
EPS CAGR |
Total Return |
CAGR |
|
|---|---|---|---|
|
PF Chang's China Bistro |
24.7% |
37% |
11.06% |
|
Intuit |
63.9% |
10.3% |
3.32% |
|
Xilinx |
31.5% |
33% |
9.97% |
Slow growers
|
EPS CAGR |
Total Return |
CAGR |
|
|---|---|---|---|
|
Boston Properties |
10.3% |
155% |
36.62% |
|
Honda Motor |
10.3% |
64.2% |
17.98% |
|
Stride Rite |
4.51% |
96.7% |
25.3% |
As you can see, the fast growers don't always beat either the market or the underappreciated slow growers. How could the slow growers soundly beat not only the S&P 500, but a number of fast growers as well? Two words: Expected growth. The fast growers had too much expected of them, and the slow growers too little. Let's use one fast grower and one slow grower as examples.
In January 2003, PF Chang's China Bistro carried an average P/E of 50, and Stride Rite carried an average P/E of 14. Clearly, investors initially expected much more from PF Chang's than they did from Stride Rite. Fast-forward to today: While PF Chang's diluted EPS growth of 24.7% is impressive, it's far less than what the market expected. On the other hand, the market expected little to no growth from Stride Rite. But the company managed nonetheless to eke out a 4.5% EPS gain, paid out a healthy dividend, and has continually used its cash to repurchase its cheap shares.
Foolish final thoughts
Some of you out there may have realized that the fast growers that failed to beat the market may actually be the more intriguing values. After all, they've performed well, but their share prices haven't changed by nearly the same amount, which makes their valuations much more attractive now than three years ago. I wouldn't argue with this line of reasoning. Indeed, Intuit, along with several other companies among the 91 stocks in the screen, happens to be a Motley Fool Inside Value pick.
Clearly, growth alone isn't enough to deliver market-thumping returns. A reasonable certainty of outperformance requires an understanding of whether expectations are too high or too low, given the current share price. That's basically what Philip Durell does on behalf of our growing Inside Value community. Subscribers receive our complete archive of all 33 previous active picks, plus two additional recommendations in each month's issue. You'll also be able to benefit from our subscriber-specific message boards, where like-minded investors share ideas. If you're interested in learning how Philip does it, take a free 30-day trial today.
N athan P armelee does not own shares in any of the companies mentioned, though he does love eating out. You can view his profile here. The Motley Fool has a disclosure policy.
