Style 1: Growth Investing

Growth stocks are companies which are consistently and predictably growing at supernormal rates and given the visibility in their earnings trajectory, the market keeps re-rating them to levels which look obscenely high when one looks at price-earnings multiple of trailing twelve months. But proponents of this approach chose to ignore trailing multiple and, considering growth potential, feel comfortable with multiple it would be at two or three years out.

Assume Stock X trades at Rs 100 and earned Re 1 per share in FY17 implying a price to earnings ratio of 100 times. If earnings grow at 40% CAGR the forward price to earnings would keep contracting as follows: 

	FY17A	FY18E	FY19E	FY20E	FY21E	FY22E
EPS @ 40% CAGR	1	1.40	1.96	2.74	3.84	5.37
Price-Earning Ratio	100	71.43	51.02	36.44	26.03	18.59

 

At any point in time, there are very few such stocks and they generally command a high premium.

Classic example of this is HDFC Bank which has consistently grown over last 20 years- the reported EPS over this period grew at 28% CAGR while stock compounded at 27% per annum, based on conventional metric of ‘Price to book’ it was probably never cheap but even investors who entered at those ‘optically’ high multiples made money given the earnings kept coming.

More recently, some businesses that have consistently delivered high growth include the likes of Page Industries and Gruh Finance. Page’s reported EPS grew at a staggering 32% CAGR between 2007 and 2017.

In current markets, few such prominent names are PNB Housing Finance, Piramal Enterprises, Bajaj Finance, Avenue Supermarts (D-Mart) among others. Consensus earnings growth estimates for these businesses are as high as 30-50% CAGR for a fairly long period of time which is why they are re-rated to such multiples; D-Mart is currently trading at 120 times trailing earnings, Bajaj Finance at 10 times book (before QIP) and PNB Housing Finance at 4 times book.

What also matters is the quality of that growth:

• In some businesses like lending it is easier to grow, however, the real risks surface only with the aging of the loan book. Barring very few like HDFC, most lenders historically have struggled with NPAs post high growth phase.
• One should also see the impact of rapid growth on return on capital employed, whether incremental returns are maintained or getting diluted.
• Finally, high growth through inorganic route i.e. acquisitions is considered riskier and unsustainable compared to organic growth led by industry tailwinds.

Growth Investing in a way is Momentum Strategy for Investors but driven by fundamentals & not price. It is hard to get many ideas with 30-50% earnings growth at any given point in time, which is why those following this strategy generally tend to concentrate on a few ideas.

Downside: When one pays 100 times earnings with an assumption that earnings will continue to grow at 40-50% CAGR for next five years, for whatever reason if earnings growth rate falls to 20-25%, the stock could be de-rated quickly and one stands to lose significantly. Assume it falls by 50%, it would still be expensive at 40-50 times earnings for a 20-25% grower and can have further downside leading to permanent loss of capital.

Style 2: Growth Revival

There is a style of investing called ‘Growth at reasonable price’ (GARP) popularized by legendary Peter Lynch. This essentially implies buying growth companies but at a reasonable valuation. This set of opportunities are virtually non-existent in today’s market. Where ever there is even an 18-20% growth and business quality is reasonably good, stocks are trading at 30 or 40 times trailing earnings, which cannot be termed as ‘reasonable’.

Those who do not want to overpay but yet want quality businesses have to then settle for a style which we call ‘Growth Revival’ style of investing.

These are high-quality businesses but for some reason, sales & earnings haven’t gone anywhere in last 3-4 years. Given market’s obsession with growth, these are completely ignored by most market participants. They have not only been through a serious time correction, a lot of these have seen 20-30% price erosion and are now available at a valuation which we believe are reasonable. But without earnings growth, there is no money to be made, and without earnings growth, they will never catch market’s fancy hence no scope of re-rating either. The good part though is there is little to lose as built-in expectations are already low.

The key here is to dig deep into reasons for lack of growth despite it being a quality business- Was it some industry headwind like industry going through down cycle, adverse regulatory environment or were there company-specific issues like lack of installed capacity, management change etc.

Once you have a grip on reasons behind lack of growth, it is a matter of taking a call on what would change these circumstances and when would it likely to materialize. It is relatively easier to take a shot at former (what) versus the latter (when), which is why this strategy needs patience, things could take longer to play out but when it does, one stands to gain not only by earnings growth but also re-rating leading to stronger upmove in stock price, and all of this at a lower risk.

Downside: Its hard to have a permanent loss of capital following style 2, however, there could be significant opportunity costs. Also, there will be positions where thesis may not play out at all so this has to be more diversified vs growth investing.

Its all about forecasting

Ultimately investing is all about future earnings and whether you follow style 1 or style 2, one has to make a bet on likely future earnings. In the first strategy, one is betting that earnings growth momentum would continue whereas in the second strategy the bet is that earnings growth would revive. Risk-return characteristics of both strategies are fairly different.

How are we positioning our portfolio?

We prefer to stay away from crowded trades and such opportunities also fall way out of our valuation comfort zone. We prefer growth at a reasonable price (GARP) style however given lack of such opportunities in current markets, we are getting more inclined towards Style 2 ‘Growth Revival’ and have added three such positions to the portfolio this year.

Disclaimer: This is not a recommendation to Buy/Sell. Read complete disclaimer here.