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Growth Stock Disaster

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May 07, 2008 – Comments (3)

The Fool has a very good article written by Joe Magyer titled "The Wall Street Myth That Could Destroy Your Portfolio."

I have been critical of growth stocks for a few reasons. The very nature of the assumption of a growth rate over say 5 or 10 years is to believe in perpetual growth and in denial of the natural business cycle.

Looking at Magyer's work, there are a lot of high growth estimates, so I picked 25% to look at and plotted a graph of what 25%.

Percent growth assumption

The blue is 25% growth per year, whereas the pink is  if you had 25% growth each year based on the starting year, so say $100 million the first year, $125 million, then $150 million and so on.  By the 5th year you have $305 million with 25% growth and only $225 million with the plan to increase the business by a fixed amount each of the next five years.  For that last year with a 25% growth rate you need to increase the business by about $60 million verse $25 million.  You've truly got to ask yourself how any business can meet this kind of expectation that the growth rate fabricates.  Do people really see how much bigger the numbers have to be in only five years with some of the insane growth expectations?

The thing is, if you actually read presentations few forecast this kind of growth.  In the sample business might be projection to have 125% growth in 5 years.  That isn't a 25% growth rate, but 17.6% growth growth rate for 5 years.  In this model the business is expected to triple in 8 years, that's a growth rate of 14.7%, and at 10 years it is 13.3%. 

But, this declining rate of growth isn't linear.  Say the projection is that the company will grow to 4 times the size in 12 years.  It looks like 25% for each year, the size of the business is bigger each year so the rate of growth is declining.  The following graph shows the degree to which it is declining with each additional year.

Declining Growth Rate

But, that isn't the worst of it.  It is much more difficult to grow a business as it gets bigger. There is always clients that discontinue using a company's products.  So, to maintain growth, it must increase the total sales, but the number discontinuing services as the company gets bigger is increasing so the number of replacement clients required is increasing just to keep up.

So, growth stocks are a great scam for speculation because people haven't studied them enough or it would be common knowledge the entire theory around them is absurd.

3 Comments – Post Your Own

#1) On May 07, 2008 at 1:59 AM, EScroogeJr (< 20) wrote:

The theory is that a business like MSFT in 1980 can show such exponential growth for 20 years or so. But the problem is that a stock like baby MSFT would often be valued as if the top point on your graph were taken for granted and the growth were to continue beyond that. That's why I generally avoid growth stocks whose forward PE is more than 30.

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#2) On May 07, 2008 at 3:46 AM, TMFSpiffyPop (99.41) wrote:

"scam"? 

You've simply assumed that companies can't hit consistent growth rates as they scale larger. Some do. Many don't. To think this is a "scam" or to broad-brush all "growth companies" as an absurd theory" of investing seems to have gotten you to a point that I doubt Joe intended from his article.

I personally find the "growth" and "value" labels as very misleading and about as helpful as arguing over whether MVPs in sports should be the "best player" or "the one who means most to the team" -- as if one of those is absolutely right and the other "wrong." Rather, these are just lenses, and each has its use.

If we're going to insist on these labels, I consider myself a "growth stock investor" and have been very happy with my returns invested in companies exhibiting strong top- and bottom-line growth over time as distinguishing features of the investments. --DG 

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#3) On May 07, 2008 at 9:47 AM, dwot (47.53) wrote:

Excuse me Dave, Joe's article is about research that is showing how far wrong analyst's estimates tend to be.  Mine is showing the math that does say the the whole concept of growth rates is absurd.  The math here is indisputable.

That we live in an world where regulators have decided to ensure there is inflation mean there is a required "growth" rate to make up for the increasing money supply.

Business life cycle

The beginning of a business life cycle does match an exponential growth curve and further into the business it is doomed to failure.

There isn't a person alive that has developed investment theories in a sustainable environment.  It has all been developed on increasing exploitation and unpresidented population growth.  The ability to exploit has pretty much run out.  Technology isn't going to give the type of increases it has in the past.  Out sourcing has probably reached a limit of sorts.  Every place that you look as to how business increased profitability and growth suggests those kinds of actions can not be repeated with the same results.  The business world has profits quite well built into it at poverty wage levels.  There has been exponential population growth over the past 500 years.

World Population, 12000 Years

How can a business not do well with this kind of population growth to exploit?  The growth phase of a business can be extended as it expands into other markets but it is ultimately unsustainable.

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