Most of the time, investing in growth stocks yields huge returns over a five- or a 10-year period. Then, sometime between or after this period, these high-value plays are no longer considered growth stocks any more and their return functions start to normalise somewhat. This is basic investment lore that most investors are familiar with.
What is often missing from the analysis that investors carry out when looking at these sorts of companies is a realisation that the process of a stock going from “growth” phase to “normal” phase is not a straight line: it’s frequently messy and full of early warning signs such as medium-term declines.
ARM Holdings: Your Essentially Run-of-The-Mill Stock Pick
There are few better examples of such a company on the UK markets in this transition right now than that of chipset maker ARM Holdings (LSE: ARM) (NASDAQ: ARMH.US). ARM has capitalised big time off the surge in smartphone – and in particular iPhone – users in recent years as a result of its contract with Apple to supply the relevant chipsets installed in the Cupertino tech company’s insatiable mobile innovations.
As a result, if you had gotten into ARM five or 10 years ago in a big way, you would now find yourself sitting on piles of cash. In the past five years, ARM has leaped 546% in value; over a 10-year period, it’s made 955% gains, and that is despite being caught in the crossfires of one of the worst recessions in history that mauled stock valuations.
Then in the last year, something changed, as ARM tumbled 10%. The evidence is clear this trend is exponential (i.e. ongoing at an increasing rate): if you pull the chart out to reflect year-to-date declines, ARM shows a 17.5% drop in value. And yet ARM is still 80 times earnings – in other words, in growth stock territory.
What’s happened is that ARM is still operating in what is considered deep growth-stock territory: namely, the manufacture of complex parts for mass-scale mobile devices. Given the recent positive momentum in the stock market generally, ARM has been able to hold onto its high market valuation for perhaps a little longer than it usually ought to. For make no mistake about it, this is no growth company any more.
Lacking In Growth, High On Liquidity
Evidence of this fact is borne out in the company’s earnings statements. In the first quarter of this year, ARM made £187.1 million in sales. That number declined slightly to £171.2 million in the second quarter. It’s not especially significant here that sales declined quarter-on-quarter: different seasons tend to produce varying results, especially in the case of tech companies. What’s more important is the overall stability of the earnings rates.
ARM pointed out in its earnings presentation in July that USD revenues from North American operations were up 17% year-on-year while GBP revenue overall has increased 9% in the same period. It also highlighted the fact that it generated net cashflow of £86.7 million, meaning the company is comfortably profitable and as such that its balance sheet is nice and liquid.
Which is all great news, of course, except for the reality that such facts alone do not justify a forward earnings valuation of 40 times future earnings. Growth in North America is what every company with operations there pretty much has experienced in the past 12 months, as the economy is starting to get going again after a half-decade slump.
What’s more, producing a healthy cashflow is news to the chief executives of most growth companies, who are constantly dealing with cost of capital equations as they try to figure out new and even more creative ways to plug next year’s hole in the income statement other than by diluting their shareholders, most of whom are sitting on huge short-term gains.
In other words, ARM is a great company: it’s just not worth £12.8 billion in market value. It’s probably, in all fairness, worth about half of that right now.
If the stock declines another 40%-50% over the next 12 months, you may wish to consider picking it up at those levels. If ARM goes on an acquisitions splurge of nimble high-growth subsidiaries before then you might want to think about buying this stock, but not before the market has priced in a similar valuation penalty for the act of ARM’s management spending its cash holdings.
Instead of Chasing ARM, Try This Pick Instead
If you are hunting around for a real growth share, take a look at the Motley Fool’s number 1 pick on the LSE in this special report on the company here. You will instantly notice that not only is it much smaller in size to ARM by comparison, but also that its earnings are growing at healthy clip, too.
Typically for growth companies, there is always somewhat of cash shortage on the balance sheet. And that, combined with big earnings momentum, is your first indication that the pick is growing at a rate you can count on generating a P/E valuation in the high double digits, since by that measure it’s reinvesting in its own rapidly adopted technologies.
So don't delay, click here to get your report immediately and without any obligations while it's still available!
Daniel Mark Harrison has no position in any shares mentioned. The Motley Fool UK has recommended ARM Holdings. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.