Buying growth stocks can be like putting your portfolio on steroids.
Suppose you have two stocks. Stock A has earnings of $1, trades at $10, and is growing at 10% per year. Stock B also has earnings of $1, but it's trading at $25 and growing at 25% a year. After a decade, if both stocks are trading at 15 times earnings, high-growth stock B will have returned more than 450%, while stock A will have returned less than 300%. Thus, growth is clearly superior.
So how can it be that according to Ibbotson Associates, between 1968 and 2002 value returned 11% annually, while growth only returned 9%? With the math so clearly favoring growth, how can value possibly outperform growth over the long term?
The downside of steroids
The problem is that two of the assumptions above, while seeming reasonable, are actually extremely optimistic.
The first unrealistic assumption is that the growth stock is trading at a P/E of 25. It's relatively difficult finding stocks that will consistently grow 25% annually trading for such a low P/E. And if you buy when the P/E is 40, your returns are actually less than you'd get from purchasing the cheaper value stock.
But the bigger unrealistic assumption is that the company will grow 25% per year for a decade. While some companies are able to grow at a high growth rate for a few years, relatively few can sustain a high rate over such a long period. Just think about the companies you knew about 10 years ago that have sustained that sort of growth. Starbucks (NASDAQ:SBUX) has. Symantec (NASDAQ:SYMC) has. And Yahoo! (NASDAQ:YHOO) has. But beyond these three, it's hard thinking of companies that have cleared that hurdle.
There are two big challenges in achieving high long-term growth rates. First, as the company gets bigger, it has to do more and more to achieve the same growth. Fifteen years ago, Starbucks had 165 locations, so growing by 25% meant opening about 40 coffee shops. Now that Starbucks has 12,000 locations, 40 new stores won't do. It would have to add 3,000 stores -- eight every day -- to keep the number of locations growing at a 25% rate.
The second challenge is that growth invariably attracts competition, and competition crimps profits. It's no coincidence that in the late 1990s, the Internet search space was crowded -- everyone wanted to be the next Yahoo! Despite Yahoo's massive early lead, Google (NASDAQ:GOOG) has taken control of the market. Now Google itself is being targeted by those folks up in Redmond.
You see it again and again with growth stocks. Does anyone consider it odd that IBM (NYSE:IBM) created the PC -- one of the most successful growth products in history -- yet doesn't actually sell them any more? Really, it shouldn't be so surprising. That growth attracted so much competition from Dell (NASDAQ:DELL) and Hewlett-Packard (NYSE:HPQ) that IBM could no longer sell PCs at a reasonable profit.
The best growth stocks
With all these problems, what's a Fool to do? Well, it is possible to make piles of money in growth stocks, but you have to be discriminating.
First, keep looking for companies with growth potential, but don't pay too steep a price. It will eat into your returns.
Second, try to find businesses with solid barriers against competition, even if the growth rate isn't quite as high. The growth will be more sustainable, leading to superior long-term returns. For Starbucks, the barriers included the company's brand, ubiquity, and quality products. For Symantec, the barriers included Symantec's solid reputation, institutional knowledge, and control of the distribution channels. In combination, these barriers slowed competitors and helped shareholders achieve excellent returns.
The Foolish bottom line
So don't just buy any growth stock, but look for companies with significant competitive advantages trading at cheap prices. It's no coincidence that these are the types of companies that we recommend in our Inside Value newsletter. If you're looking for such stocks, you can get a month-long guest pass here to see all our picks.
Fool contributor Richard Gibbons' thumb was seriously injured in a hideous pistachio accident. He does not have a position in any of the stocks discussed in this article. Symantec and Dell are Inside Value picks. Starbucks, Yahoo!, and Dell are Stock Advisor recommendations. The Fool has a disclosure policy.
