As a total cheapskate, er ... frugal person, a value style naturally fits my personality. I've come to realize, however, that limiting my investment universe to stocks that screen cheaply on various valuation metrics (price/book, price/earnings, or price/sales) is not a good move. Equally important (if not more so) is ensuring that the companies in my portfolio have an effective strategy and the financial wherewithal to grow earnings and cash flow for sustainable periods of time.
How did I come to this realization? Well, I might say that I just read commentary from Warren Buffett, Bill Miller, and many other top-tier investors who have repeatedly noted the importance of not just having attractively priced holdings, but also owning good companies at attractive prices. But although I respect and admire these investors, it was still hard for me to pass up on a dirt cheap mediocre company for another, better company that was trading at only a modest discount to my interpretation of fundamental value.
Math demonstrates growth's value
Let's say you have two stocks, GrowthCo and Mature Inc. GrowthCo is expected to earn $0.67 per share this year, while Mature Inc. is expected to earn $1 per share. Over the longer term, however, GrowthCo should be able to increase its earnings by 10% annually, whereas Mature Inc. isn't expected to see any earnings improvement because it's in a highly cyclical industry that requires significant investment just to maintain its existing earnings power.
Fears of an economic slowdown drive both stocks down from their normalized valuations of 10 times earnings for Mature Inc. and 15 times earnings for GrowthCo. Mature Inc. plunges to $6 per share from $10, while the less-cyclical GrowthCo dips to $8 per share from $10.
If I believed both companies were on track to achieve their long-term earnings expectations, my natural instinct used to be gravitation toward Mature Inc. rather than GrowthCo. Heck, anyone can see that Mature Inc. is at a 40% discount to intrinsic value, while GrowthCo's stock price was only knocked down 20%. But this may not be right way to think about it.
Let's look ahead five years, assuming earnings at both companies materialize as initially expected. Mature Inc. would still be earning $1 per share, but GrowthCo's earnings would have increased to $1.07 at a 10% annual rate. At their normal valuations, Mature Inc. would have rebounded to $10 per share, whereas GrowthCo would have jumped to just over $16.
A Mature Inc. shareholder would have a pretty nice total return of 66% (almost 11% annualized) from the closure of the wide gap between the purchase price and its fundamental value. Nonetheless, a GrowthCo investor would have done even better, enjoying a 100% return (15% annualized).
GrowthCo's better returns come from compounding multiple expansion increases on top of earnings growth. Holding other variables constant, the price/earnings increase from 16 times to 20 times would provide a 25% price rise, while earnings growth boosted the price by 60%. However, because a stock price results from multiplying valuation by the valuation criteria, not by adding them together, the total return of 100% is 15 percentage points greater than what those static numbers indicate.
Starbucks drives the point home
That hypothetical example above demonstrates the impact of compounding valuation increases on higher earnings, but real life has helped me truly understand its power.
During a 1998 stock market plunge now called the "Asian Contagion," I purchased shares of Starbucks
As it turns out, my perspective was correct, and the stock bounced back quickly. I sold the majority of my shares within six months, feeling smug at getting nearly $7 per share as the valuation partially rebounded (to somewhere around 39 times forward-year estimates).
I sold most of the rest of my shares within two years but held onto a very small number of shares from the original purchase to continue receiving the company's annual report (and the attached coupon for a free Starbuck's beverage). Those shares are now trading for over $35 (42 times fiscal 2007 estimates).
Needless to say, selling those Starbuck shares in 1999 and 2000 was not an optimal decision. The gain I have on those few remaining shares is over 800%! Without earnings growth, the expansion of the earnings multiple from 27 times to 42 times would have provided a nice 55% return. If the stock price only increased because of earnings growth from $0.14 to the $0.85 projected for fiscal 2007, my gain would have been just over 500%. But compounding these factors upon each other results in a much larger 800% return.
Admittedly, this Starbuck's example is extreme, since the company is one of the best-performing stocks over my holding period. Nonetheless, it clearly demonstrates the power of combining multiple expansion and rising intrinsic value.
Finding reasonably priced growth companies
Today's stock market is surprisingly full of high-quality growth companies trading at reasonable valuations. Large, dominant companies falling into this category include Wal-Mart
Among mid-sized companies, pressure-sensitive label maker Avery Dennison
Buying a stock at a discount to its current value is a great start to a successful investing strategy, but if you're a buy-and-hold investor, don't ignore the importance of finding companies that can grow their fundamental value. Over the long haul, compounding improvements in intrinsic value (i.e., earnings or cash flow) with higher valuations can provide extraordinary returns.
Many of The Motley Fool newsletters seek companies with attractive valuations and solid growth prospects. Dell and 3M are Motley Fool Inside Value selections. Dell is also a Motley Fool Stock Advisor pick.
If you're interested in learning more about value stocks, you can get a free 30-day trial to Inside Value by clicking here. And if you're interested in learning more about growth stocks, take Motley Fool Rule Breakers for a 30-day free trial.
Fool contributor Warren Gump owns shares in Avery Dennison, Washington Post Co., and Starbucks. The Fool has an ironclad disclosure policy. Warren's happy when his intrinsic value increases but prefers that growth in waistlines compound on other people.