MARKET NEWS
Maximise the Upside

By Nigel Roberts
December 15, 2000

Chippenham, Wiltshire – You would think that no one was interested in growth investing anymore, and that investing in high tech stocks was just for the (small f) foolish investor. Is growth investing, and high-tech growth investing, now dead and buried? Of course it isn't!

In yesterday's Fool's Eye View Maynard Paton (TMFMayn) wrote about investing in companies that show some "obvious and immediate investment value", as a way of avoiding getting your investment fingers burnt. Maynard suggested that you should try to "ensure the earnings and dividend yields are as high as possible, to limit the investment downside." He added: "remember, although the stock market may think so sometimes, companies never offer guaranteed growth prospects."

Maynard has quite a different investment strategy to myself. But we do agree on many of the principles, such as long-term investment and finding and buying shares only in quality companies. But it is in this last area that we differ most in our investment ideas: how do you define what a quality company actually is? Maynard likes to try to minimise the downside of investing by looking for a margin of safety, while I am looking always to maximise the upside by looking for the greatest potential.

So let me offer an alternative to Maynard's obvious and immediate value, by suggesting that you should look to invest in the obvious and future value of a company.

(Definition of "obvious": Easily perceived or understood; quite apparent. I would hasten to add at this point that I don't think any sort of investment is ever easily perceived or understood, or quite apparent. You have to put a lot of hard work in to determine the "obvious"!)

The issue of volatility, and learning to love risk

We all know that there is a direct link between risk and return. The bigger the return you hope to get, the bigger the risk you will have to take in order to achieve it. If the thought of £5,000 turning in £4,000 or even less makes you feel ill; if the worry that it might turn into £2,000 scares you to death; then think seriously about whether investing in the stock market is really right for you. Maybe you would be better off sticking the money into one of the high-interest Internet accounts around paying 7% before tax. The money will grow slowly and surely, but it won't grow fast.

But if you hope to turn your £5,000 into £10,000 in five years, or into £26,000 in ten years you will need to achieve a compound growth rate (after tax) of 20% a year. To get a growth rate of 20% a year you need to be able to embrace risk; indeed, you need to be able to welcome risk into your life with open arms! The more risk you are willing to accept, the higher your potential rate of return, and conversely the greater the potential losses.

Many investors equate the short-term volatility of a company's share price with the risk of investing in that company. This is not necessarily so! Sure, if you were investing in the stock market for only a year, then volatility should be a big concern. If you needed your money in a year, a big decline would be devastating. But if you are investing for the short term then you should not be putting that money into the stock market at all!

Most people, however, are investing for retirement, and have investment time horizons of 10 years, 20 years or even longer; so short-term share price fluctuations are pretty much irrelevant.

No one can predict how any company's share price will perform over the next few days, weeks or months, but if you can look 10 years down the road, then it is pretty certain that the share prices of most high-quality companies will be higher than they are today. The trick is that you must always select the companies to invest in with great care.

So buy and hold for long-term growth

What you should do is maintain a buy-and-hold strategy. We always talk about the importance of buying shares in high-quality companies and holding them for 5 years, 10 years or longer. But few investors actually manage to do it. What most investors (and media pundits) do is to concentrate on short-term volatility, and this leads to short-term conclusions being drawn.

Don't confuse volatility with risk. If you do, you will build a portfolio that's designed simply to reduce volatility. This type of thinking will keep you out of those companies with good long-term prospects or cause you to invest too little in them for fear of short-term corrections. Remember, volatility works both ways, and the longer your investment horizon, the less you have to worry about volatility.

Investing is all about tomorrow, and what will happen in the future. Identify the sectors that will be the driving forces of our economy and have the courage of your convictions to invest in them!

Be less diversified

One way people try to limit risk is to diversify their portfolios. Instead of putting all their money into one or two companies they spread their money across different companies and different sectors. Some diversification is reasonably sensible, after all few of us – apart from TMFPyad – can really enjoy the opposite extremes of sitting on cash or risking being 100% invested in just one company. But too much diversification damages the performance of your portfolio. Owning shares in a maximum of about 12 companies will provide all the diversification most people would need.

But don't invest in small cap shares!

It can be tempting to assume and believe that small companies with small capitalisations will grow quicker than large companies with large market capitalisations. Well let's have a look at the UK's largest company by market capitalisation: Vodafone (LSE: VOD).

By how much did it grow its turnover last year? Answer -- 134%
How much did it increase profits by? Answer -- 62%
How much did earnings per share increase by? Answer -- 26%

Most of your investing efforts should be directed towards finding the best investment among the larger capitalised shares. Don't make the mistake of thinking that small cap shares really have the intrinsic ability to grow faster than large cap shares. Why take the increased risk of investing in small caps to try to find growth when you can find it among the large cap stocks?

Technology is still the future

Is tech stock investing now dead and buried? The answer is a clear "No". The future will still be dominated by the increased use of technology. The growth in wireless communication is not going to stop, we are going to see the creation of huge new markets for microprocessor chips, and we will see a revolution in the way that we live and work. The revolution is still happening, no matter what the stock market has done recently.

In the long term, I think the picture is very clear. Technology is still the future and now is a great time to buy those fundamentally solid, high quality technological leading companies quoted on the stock market. In the longer term, if you want to achieve a high rate of return on your investment, you are better off owning high tech growth stocks, and holding them through thick and thin. But you must have a personal tolerance to volatility, both emotional and financial. If you need your money in a year or two, don't invest in growth, don't invest in high tech -- don't invest at all!

Where Next?

Obvious and Immediate Value: Maynard Paton (TMFMayn) on reducing the downside.