The Problems With Growth Stocks
They may be an excellent choice, but you should be aware of the catches
This is the seventh article of a series. The previous article is “Compound Interest: Natural Mathematics or Pure Greed?”.
We think that 100 golden eggs is a good price to pay for a magic golden goose that will provide 10 golden eggs per year, forever. And 200 golden eggs is equally a good price for the one that provides 20 golden eggs per year, forever.
Now, what is the good price for a golden goose that has an increasing production each year? Like 10, 11, 13, 16, 20, 25…
For sure the price should be more than 100 golden eggs because 10 golden eggs is the minimum production. I would say more than 200 golden eggs, because in the sixth year this golden goose will be providing more than 20 golden eggs (25), forever and probably will continue to increase the production for some time.
Therefore, paying the triple, 300 golden eggs, for a golden goose that currently provides 10 golden eggs per year may prove to be an excellent decision over time.
It is important to remember that the only worth of a magic golden goose is its production. The worth of a golden goose that provides no golden eggs is zero. Why expend some golden eggs buying a golden goose that will not return any golden egg for you? Please, don’t think of having dinner (eating it).
It is time to leave the fairyland and enter the stock market. Instead of “golden goose” we will say company. Instead of “golden egg” we will say money, dividend, profit. I prefer the fairyland, it is much simpler!
1. IT IS ALL ABOUT (OPTIMISTIC) PROJECTIONS!
The main problem with growth stocks is that the evaluations rely on (optimistic) projections.
You may argue that investing is about the future and so the evaluation of any company relies on projections. This is true. But the financial projection of a solid, profitable, traditional company has small room for “creativity” and a huge chance to be confirmed.
I hope you understand what I mean with “creativity”.
2. It must not stop the fast growth
This is very common: a growth stock company releases the numbers of the quarter showing excellent, increased profit and the price of its shares falls deep, because in its guidance the company alerts that it will have a smaller growth on next quarter.
Do you see? Your investment is under pressure. It is not enough for the company to have strong profit. It is not enough to grow. It must keep the strong growth.
It is not a robust investment. It is fragile.
3. The whole picture doesn’t make sense
Now, let’s imagine the (somewhat rare) case of some small, profitable, young and fast growing company. The company is growing at high rates for now. And we expect that 10 years from now, growth year after growth year, this company becomes a solid, big, mature, profitable company (it will keep growing but by modest rates).
So far, so good.
Excellent investment? Before answer, we have to consider two factors.
- In ten years a lot of things happen. So, hardly the projected numbers will come true. They will be much better or much worse.
- What is the relation of the price today and the future value (profit) of the company?
What I mean is: No way I am going to pay 100 golden eggs today for a golden goose, that 10 years from now, if everything runs fine, will give me 10 golden eggs each year.
This article is about investment, buy and hold. It is not related to short time speculation, although it may provide some utility in this area too.
To be continued
I will post here the link for another article.