Most of us have seen much-loved growth stocks crash land when their promises turn out to be anything from optimistic to borderline fraudulent. Other times, the expected growth does come – but investors were too excited in advance, which took the share price to unsustainable levels. Even as profits grow at these companies, their price drifts back to Earth, letting out air, as the formerly sky-high P/E multiple falls back to something reasonable.
Good to grow
So… to be a successful growth investor, you simply avoid the profitless promises and the sky-high multiples, right? If only it were…
Most of us have seen much-loved growth stocks crash land when their promises turn out to be anything from optimistic to borderline fraudulent.
Other times, the expected growth does come – but investors were too excited in advance, which took the share price to unsustainable levels.
Even as profits grow at these companies, their price drifts back to Earth, letting out air, as the formerly sky-high P/E multiple falls back to something reasonable.
Good to grow
So… to be a successful growth investor, you simply avoid the profitless promises and the sky-high multiples, right?
If only it were so simple.
For starters, many great growth stocks may not show much of a profit for years for good reasons.
I’d put Amazon into this category, although others disagree. I believe it could show big cash profits, but it’s reinvesting for the future.
Another example closer to home is ARM Holdings (LSE: ARM).
ARM has always traded on a high P/E – at least 50 during the past five years – but it’s still seen its share price quadruple.
What’s more, there’s another kind of growth stock that in my view is best avoided.
This is the “too good to be true” kind of profitable growing company, which often attracts stock pickers a bit savvier than the average punter.
With these companies, strong profit growth is clocked up over time and yet the valuation still seems reasonable – almost suspiciously so.
Eventually the story unravels, and it turns out the market was right not to bid up the share price after all.
Look at it grow
Plus500 (LSE: PLUS) is an interesting case study here – not least because in the eyes of at least one buyer it’s turned out to be a genuine fast-grower worth owning.
(More on that later.)
However, personally I have had my doubts.
Plus500 provides broking services with no commission in Contracts for Difference (CFD), a hitherto fairly obscure kind of derivative – at least among private investors – that enables you to speculate on price movements without owning the shares.
The company only listed on AIM in the summer of 2013, but it’s had a very eventful two years.
Having begun trading at 115p, the shares cost 700p by April 2014!
Yet Plus500 was growing so quickly that some suggested it was still a great buy, even then. In the last financial year, both revenues and profits doubled.
Notably, the P/E rating never got much above 25 – and it typically sported a mid-teen rating.
Plus500 even paid a high dividend.
No wonder it appealed to investors who don’t want to own ‘jam tomorrow’ companies but who like to snap up growth when it’s priced fairly.
I like that, too… but I never bought the shares.
It didn’t add up for me
While I agree Plus500 never looked very expensive given its growth, other things gave me pause for thought.
For starters, I didn’t see why revenues should be growing so spectacularly. Neither online trading nor CFDs are new innovations. Risks here might have been that the accounts weren’t telling the whole story, or that Plus500 was cutting corners or taking risks compared to others such as IG Group (LSE: IGG).
Another possibility was it could’ve been simply overspending to acquire new customers, and that one day the music would stop.
I didn’t know, but I wondered and that was enough.
I also couldn’t see why the founders had floated a company that seemed to be a money-printing machine right before its tremendous growth spurt, especially when it almost immediately began kicking out high dividends, so presumably didn’t need the cash.
It was hardly reassuring, either, when several founders sold a big chunk of their holdings last Spring (although you might not have blamed them given the share price rise).
Finally, Plus500 is an overseas company listed on AIM.
In theory that shouldn’t be a yellow flag, but so many have gotten into trouble that, for me, it is.
Growth to go
So was I right to avoid it? The reason I’ve picked Plus500 as an example is because I’m still not sure…
In recent weeks Plus500 began freezing UK customers’ accounts pending further investigation, following the Financial Conduct Authority looking into its customer identification procedures.
Its shares were briefly suspended, too.
As you’d expect, its price duly plunged, momentarily falling to around 250p.
At that point I thought I’d dodged a bullet.
However, the price soon recovered ground following further statements from the company.
Moreover, Plus500 has since received a 400p bid from gaming firm PlayTech (LSE: PTEC).
While 400p is well down from the peak, it might well be a relief to some worried holders.
I don’t want to get too ‘Johnny Hindsight’ about these events.
I never looked deeply into Plus500, and I certainly don’t claim to have foreseen the very particular issues of recent days.
Besides, turning 115p into even 400p in two years will be a great result, if the deal goes through – hardly one to boast about avoiding!
However, there are thousands of shares on the UK market you might buy – and tens of thousands of international candidates.
Stock picking is inevitably as much about passing on dozens of interesting-looking prospects as zeroing in on the winners.
So while Plus500 came onto my radar as various publications and bulletin board posters made the case for its soaring shares, those yellow flags were enough for me to leave it blip while I looked elsewhere.
And I don’t think I was wrong to do so.
You can grow your own way
That’s because I believe good investing is about applying a process over the long term, not calling every share right.
And when it comes to growth stocks, I believe my safety first approach will serve me best in the long run.
Even if history ultimately shows that all I can do when it comes to Plus500 is toast the good fortune of others…
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Owain owns shares in Amazon. The Motley Fool has recommended shares in ARM Holdings.