How Owning Great Businesses Can Reduce Your Returns

While I’m a value investor at heart, I am not averse to owning growth stocks – particularly where I think I might own them for years.
Indeed, because I tend to trade my value shares when the merits I see in them has been understood by other investors, some of the longer-term winners in my personal portfolio are growth stocks (Tesla, anyone?).
However, I am very choosy when investing in companies that I see growing places.
In particular, I’ve lost that early enthusiasm many of us have when we first start investing for ‘jam tomorrow’ shares.

Jam tomorrow shares are companies that are typically losing money today but touting huge returns in the future.
Hence you go hungry in the present, believing that one day you’ll be knee-deep in jam.
If you don’t like jam, you may not relate to this. Feel free to call them “chocolate tomorrow” stocks or even “beer tomorrow” ones!

Jammy dodgers

Anyway, the trouble is very often the jam never arrives.
That leaves you in an even stickier predicament, staring at a big loss of capital and little prospect of clawing it back.
So because the risks are so high, I’ll nowadays usually only put my money into firms that promise a lot but with little yet to show for it *if* I believe something truly transformative is taking place.

This was the basis of my multi-bagging investment in the US electric car manufacturer Tesla, which I’ve already bragged about once in this article.
I think Tesla has a slim but clear chance of disrupting the entire automobile sector, which could change the world – and be massively profitable, too.
In contrast, a “ho hum” profitless company that is boasting it could improve some obscure industrial process or another that has a great idea for a mobile phone app – they usually don’t interest me at all.

You need to profit, too

Once you’ve whittled out all the mundanely profitless companies and those promising the moon (and no, that’s not Tesla – it’s Mars that CEO Elon Musk is interested in…) then there still remain huge challenges in selecting growth stock winners from the losers.
But notice I said ‘stock winners’, not ‘winning companies’.

Now, this might strike you as odd. Aren’t we business-focused investors here at The Motley Fool?

Very much so, but we do care about valuation, too.
After all, as an investor you ultimately only make a profit if your shares go up – or if you’re paid substantial dividends over time.
A world-famous sexy business whose share price goes nowhere for a decade is not much use in investing terms, except for the fun of name dropping your ownership at parties (and even then only at parties where nobody knows about investing…)
And the trouble with growth stocks is that their price very often trades at a premium rating versus their current earnings, cashflow, growth prospects, or any other metric you prefer.
This means such companies have to grow earnings enough to justify their share price today, let alone for it to rise tomorrow.

Without such a share price rise, the company may gain market share and the employees may win awards for Best New Widget 2015 – and perhaps they’ll bag a gleaming new corporate HQ along the way – but poor old shareholders won’t make a penny.

Unlucky 13 for some

And what happens if the hoped-for stellar growth in earnings never actually materialises?
Well, then it’s a long way down from an optimistic P/E rating of 40, 50 or even 100 to a more humdrum multiple.
Consider, for instance, the history of ARM Holdings (LSE: ARM).
This chip designer’s share price touched £9 in March 2000, as investors got excited – quite correctly – about the prospects for ARM’s design prowess and its lightweight business model.
However, ARM shares were knocked back in the dotcom bust – and it took 13 years for its valuation to recover to 2000 levels again.
That’s a long time to be patient in anyone’s book.
So much for the shares, but did ARM’s business perform as limply?
Hardly! Revenues grew eight-fold over the same period and profits soared even faster.
By any measure, ARM – the business – had an incredible 13 years.
And there’s the rub when buying growth stocks.

Too high hopes

It all comes down to multiples and expectations.
The price investors were prepared to pay for ARM in 2000 meant that it was trading on a P/E multiple of well over 250.
For context, the FTSE 100 has since 1990 on average traded on a P/E of less than 15.
Investors justified the huge premium for ARM’s shares by its incredible prospects – and as we’ve seen they were to some extent right to be so optimistic, given how revenues and profits surged.
Still, by March 2009 ARM’s P/E ratio of 250 had been reduced to around 25, as its shares languished in the financial crisis.
And even when the company’s valuation finally recovered by 2013, the P/E rating had still only climbed back to 80.
If ARM had maintained its former P/E ratio of 250, the share price would have been three times higher!

Down but not out

Today ARM trades on a P/E rating of about 55 – so down still further from the P/E ratio of 80 two years ago – yet its share price has continued to climb, and is currently over £10.
What we’re seeing here is the impact of the expected high growth steadily coming through.
That growth has increased ARM’s earnings, which has brought down the P/E multiple, even as the share price has advanced.
In fact, on a forecast basis the P/E ratio is now only a little above 30, which implies that growth in earnings will continue to be strong.

Expect the expected

The lessons are clear.
Firstly, when you pay a very high price for the future earnings of a company, you need to be confident the growth opportunity is sufficiently vast and sustainable to endure the de-escalation of the P/E ratio (or whatever other multiple you prefer) over time.
That sounds obvious, but in my experience many growth investors forget it.
They presume that a company that is going gangbusters will maintain its sky-high ratios.
But the market is cleverer than that, and it knows that vanishingly few companies can grow for many decades.
Hence it begins the de-rating process years in advance.
And the second lesson?
Even if you’re a growth investor, it never hurts to bag a bargain!

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Owain owns shares in ARM Holdings. The Motley Fool has recommended shares in ARM Holdings.