Use the corporate lifecycle to fine tune your investment strategy.
Is there an optimum age for a company? At first, this seems an almost nonsensical notion. Yet, successful practitioners of the art of investing recognise that companies move through an economic life cycle. Moreover, these stages of development are, in some ways, analogous with the way humans age.
T. Rowe Price, sometimes referred to as the 'father of growth stocks' is one of the investing greats who identified that in common with people, companies pass through three phases in their life cycle:
He therefore sought out companies that were in this first growth phase, distinguishing two types of growth:
- Cyclical -- growth in unit volumes of sales and in net earnings, which peak at progressively higher levels at the top of each succeeding business cycle. These stocks are ideal for investors looking for capital gains during the recovery stage of the business cycle.
- Stable -- growth in unit volumes and in net earnings, which persists through the downturn in the business cycle. These stocks are suitable for investors who need relatively stable income.
It's a distinction that we ignore at our peril as it is to easy to buy a cyclical growth stock in ignorance of the fact that your buying at the top of the business cycle. That is why it makes sense to average out the earnings of a stock over several years.
Of course the very term 'growth company' has become somewhat debased, a term misused to describe too many loss-making companies that have no hope of ever delivering consistent growth in net earnings at any stage of any business cycle.
How do you identify a growth company?
Of course it is one thing to be able to talk about this theory and quite another to successfully apply it in practice. T. Rowe Price looked for the following attributes in a company:
- A strong balance sheet
- A high return on capital (at least 10%)
- High profit margins
- Consistent above-average earnings growth.
If these are improving, it's often a good indicator that the company is still in its growth phase.
Warren Buffett has clearly taken on board the idea that each company has a life cycle of profits and has used his own methodology to try and identify and invest in those in the growth phase.
Although he is held up as the archetypal value investor he has argued that it is a false distinction. Indeed, he has frequently chosen to invest in growth stocks that, because of their ability to increase earnings, were undervalued when he bought them.
Large cap growth stocks
Buffett minimizes his downside risk by investing in large cap growth stocks. These are very liquid and provide exposure to innovation and increasing productivity with less volatility and risk than mid and small-cap stocks. Generally large caps also have a lower failure rate than their smaller brethren because they have more diversified earnings streams, greater financial resources and more experienced management.
He has, in effect, focused on companies, thought of as mature by many. However, their growth stage has been prolonged by market leadership, quality of management and efficient use of capital resources. Thus, he's managed to pick up bargains: growth stocks that are also undervalued because they are seen as being mature.
Most of us do only manage to find undervalued companies among 'mature' businesses or those in terminal decline; or so-called 'growth' stocks that are too expensive because they ultimately fail to deliver that growth.
While simplistic analogies can be dangerous for investors, it is worthwhile to try and assess where a company is in its economic cycle. In so doing, we should find companies that are undervalued yet also possess the attributes to deliver consistent growth through several business cycles.
After all, we want our pet investments to outlive us and the only way they can do that is by continually growing and innovating.
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