Growth Stock Disaster
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%.
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.
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.