Growth stocks and Price performance

[growthinvestor]

As investors , we are keen to maximise our returns.
In turn, max returns need good price performance. 

I am still new to investing, in particular investing in growth companies (i.e. small or mid-cap penny stocks). 

I am trying to understand how to pick the right growth stocks for maximum returns. 

I have studied briefly how SG stock prices of such companies move up (not talking about down yet).

If you take HMI, Straco as examples, it seems to me such companies' stock went up to be multi-baggers due to catalysts such as :
1) a substantial and sustainable increase in revenue or EPS  and corresponding increase in profit margin.
2) announcement of expansion plans perceived to be lucrative. The price surge may be pricing in future earnings and must be maintained by a corresponding increase in revenue otherwise it may revert to the mean. 

Such catalysts can drive the price by a few folds, like "leveling-up" the stock.

If there are no such catalysts, the price may remain flat or range-bound for a few years. Worse, it may even drift down slowly. 


I also noticed it does not matter the P/E, P/B and net margin of growth companies. E.g. HMI has a P/B of 6 and P/E of > 20, net margin ~ 10%, and low net cash ,  while straco has much superior ratios and cash horde. Perhaps one need to compare the financials to peers in the same industry?

It seems that all it matters is the company can aggressively grow their revenue and profits, regardless of everything else. 

Is my view above correct? 

Would love to hear your opinions.

[RJT]

Hi Growthinvestor, company that can grow aggressively are not all that matters. It is akin to me telling you "I ran 10km yesterday", and you feel impressed until I tell you it took me 12 hours to do that. Same thing, growth is great but the question is "from what?" Any company can grow if they keep borrowing and raising capital. But those growth are worthless. The key isn't about looking at growth rate, but on the return of capital. As an example a company that can grow from $100 mil to $1 bil at a return of capital of 10% for the entire period doesn't immediately turn it into a multi bagger. It is still as valuable as it is before the growth. But not more valuable. And you are right at a few points, profit margin expansion affects ROC, which in turn affect PE expansion due to higher market expectation. Increase in margin (or ROC) and PE expansion are the twin engines for multi baggers, not increase in profit or revenue. A company can grow revenue and profit while the share price goes lower and lower if the ROC is so poor that it destroy shareholders value. And one thing to remember is not many companies can grow their margin indefinitely because they're subject to competition when there's little barrier of entry. Most companies revert to the mean in other words. Ratios like P/E and P/B are relevant to a certain point, but they don't give you the entire picture, ultimately, the question you've to answer is what is the free cash flow the company can generate for the next 10-20 years?

[growthinvestor]

Hi Growthinvestor, company that can grow aggressively are not all that matters. It is akin to me telling you "I ran 10km yesterday", and you feel impressed until I tell you it took me 12 hours to do that. Same thing, growth is great but the question is "from what?" Any company can grow if they keep borrowing and raising capital. But those growth are worthless. The key isn't about looking at growth rate, but on the return of capital. As an example a company that can grow from $100 mil to $1 bil at a return of capital of 10% for the entire period doesn't immediately turn it into a multi bagger. It is still as valuable as it is before the growth. But not more valuable. And you are right at a few points, profit margin expansion affects ROC, which in turn affect PE expansion due to higher market expectation. Increase in margin (or ROC) and PE expansion are the twin engines for multi baggers, not increase in profit or revenue. A company can grow revenue and profit while the share price goes lower and lower if the ROC is so poor that it destroy shareholders value. And one thing to remember is not many companies can grow their margin indefinitely because they're subject to competition when there's little barrier of entry. Most companies revert to the mean in other words. Ratios like P/E and P/B are relevant to a certain point, but they don't give you the entire picture, ultimately, the question you've to answer is what is the free cash flow the company can generate for the next 10-20 years?

what do you mean by "PE expansion"?

What do you think of BreadTalk http://financials.morningstar.com/ratios...ture=en-US
with respect to your opinions?

It's a company with growing revenue but with high debt, low & decreasing ROC, low net margin, yet the share price has been soaring. It has been a multibagger for the past 10 years.

It certainly seems like the traditional metrics for quality companies (ROE, net margin, low debt) do not matter so long the company can continue to churn out revenue growth. E.g. look at AMZN with low net profits year after year.

[ZZF]

Hi Growthinvestor, company that can grow aggressively are not all that matters. It is akin to me telling you "I ran 10km yesterday", and you feel impressed until I tell you it took me 12 hours to do that. Same thing, growth is great but the question is "from what?" Any company can grow if they keep borrowing and raising capital. But those growth are worthless. The key isn't about looking at growth rate, but on the return of capital. As an example a company that can grow from $100 mil to $1 bil at a return of capital of 10% for the entire period doesn't immediately turn it into a multi bagger. It is still as valuable as it is before the growth. But not more valuable. And you are right at a few points, profit margin expansion affects ROC, which in turn affect PE expansion due to higher market expectation. Increase in margin (or ROC) and PE expansion are the twin engines for multi baggers, not increase in profit or revenue. A company can grow revenue and profit while the share price goes lower and lower if the ROC is so poor that it destroy shareholders value. And one thing to remember is not many companies can grow their margin indefinitely because they're subject to competition when there's little barrier of entry. Most companies revert to the mean in other words. Ratios like P/E and P/B are relevant to a certain point, but they don't give you the entire picture, ultimately, the question you've to answer is what is the free cash flow the company can generate for the next 10-20 years?

what do you mean by "PE expansion"?

What do you think of BreadTalk http://financials.morningstar.com/ratios...ture=en-US
with respect to your opinions?

It's a company with growing revenue but with high debt, low & decreasing ROC, low net margin, yet the share price has been soaring. It has been a multibagger for the past 10 years.

It certainly seems like the traditional metrics for quality companies (ROE, net margin, low debt) do not matter so long the company can continue to churn out revenue growth. E.g. look at AMZN with low net profits year after year.

If numbers can tell everything, anyone with a high iq need not work, just whack the markets. Obviously, there are also qualitative work to be done, which is the hard part. That is what separates the good from the average.

[RJT]

PE Expansion means growing PE from 10 to 20 for example. I haven't studied Breadtalk so I can't give much of my opinion on that. But one thing is a multibagger stock in the past 10 years doesn't mean it will be a multibagger too in the next 10 years. Key is you need to understand how a business generate value.

I think you are certainly feeling confused by all the different characters of multibagger business when you look at all the ratios and numbers. So you have to stop comparing stocks based on these metrics. The thing you need to know is how a business creates value. Business that cannot create value eventually fails, whether they are a multibagger or not.

Take Amzn, the high revenue growth and poor ROC and profit lead you to theorize "Revenue growth create multibagger, the rest don't matter". So to push this further, how does a company grow revenue? Well in the case of AMZN, you need more inventories (working capital), back end IT investment, delivery network etc. In other words, growing revenue doesn't come from thin air, you need lots of capital expenditure, or growth capex as we call it. Growth capex isn't free. So where does AMZN get them from? Maybe they take on debt? I haven't read their balance sheet, but most of them would likely come from their earnings. If they are throwing all their earnings into growth capex and write them off as an expense (income statement) rather than capitalizing them (balance sheet), that means net margin, profit is going to be ultra low. And understandably, online retailers margin are not high to begin with.

So why is AMZN share price been doing so well given the poor ROC and profit? That's because they have a 'long runway'. Profit is just an accounting method. Their true economic profit, the cash flow AMZN is generating is high that's why they can afford to throw everything into growing the business and hence, the revenue. In other words, investors are buying AMZN because they expect the future cash flow is going gush in once the reinvestment slows down. In the end, it goes back to the same thing: a business is worth how much future free cash flow it can generate. AMZN can have negative FCF for the next 5 years no one cares, because if those investment, which cause the negative FCF, can result in truckload of positive FCF down the road, essentially AMZN is widening its moat, investors are optimistic about the future.

Not all high revenue growth companies are destined to become multibagger. I can create a high rev. growth company by loading on debt or keep issuing shares, which doesn't create real value. Or I can achieve that by generating really high cashflow from my operations and reinvest everything in. Again that would be high return on capital.

[grubb]

Hi growthinvestor,

The concept that you are looking for is ROIC, or ROC which is what RJT is saying. This should not be confused with ROE.

Think of every company's stock price as a DCF. A growth stock is a company which can consistently (1) earn a ROIC that is higher than its cost of capital and (2) at a higher growth rate than average companies. If condition (1) is not satisfied, it means that the company is destroying value. Therefore, higher growth will actually lead to a lower stock price.

Imagine two companies with the same growth rate at 5% but the first earns a ROIC that is higher than its cost of capital. The second earns a ROIC that is higher than its cost of capital. You will see that the first will trade at a low valuation, while the second will trade at a higher valuation.

Until here its all about math. The industry does not matter. It just happens that companies in tech, healthcare etc tend to be those that fulfill these 2 conditions, and why you see more growth stocks there.