Two months ago I laid out two of my favourite strategies for beating the market – scooping up i) industry leaders during a panic, and ii) companies going through substantial transitions.
Now I’m back with two other favourite investment approaches and these two are as old as the market itself – growth and income.
Sure, both are traditional and easy to understand, but there’s more to each strategy than buying a company with rapidly rising sales or with a yield above a certain level. I see them first and foremost as starting points. Other important qualities need to be present, too.
You need to have a different opinion
It sounds crazy, but the market sometimes underestimates the growth potential of fast-growing companies – even ones that look expensive at first glance with P/E ratios of 25 or more.
Usually, this phenomenon occurs because the market can’t grasp how rapidly a company could grow in the long term or how long it can maintain an above-average growth rate.
The first situation is usually a bit easier to judge.
For example, if we assume a company has a P/E ratio of 25 and it looks likely to grow its earnings by 30% or more in the next year, it could still be deemed attractively priced. The same may be true if the company can grow its earnings by 20% a year for two years or more.
For me, a high-quality business that can offer either of these growth projections is definitely worth a second look.
Let’s again say a company has a P/E ratio of 25, but in this case it’s clear it won’t grow earnings by 20% or 30% a year in the near future.
But there still might be an opportunity, because in my experience the market often doesn’t look more than a year or two into the future. So, the shares could still be attractive if you believe the company can grow earnings at 10% to 15% a year for five years or more.
Investments such as these can deliver substantial returns, because of the power of compound growth.
And sometimes a share will have the potential to succeed on both criteria…
The combination of events has led to the share price rising nicely
This was my assessment last March with healthcare specialist BTG (LSE: BTG), when the shares had a P/E ratio of 30 .
My research led me to believe a new royalty stream alongside sales growth from existing products would allow the company to grow near-term earnings by 25% or more. In future years, I saw the opportunity for new product launches to generate sustainable growth of 10% or more for five years.
It helped BTG’s executives boasted a track record of meeting their own plans and expectations. Fortunately, they did so again as earnings in 2013 increased by 28% and BTG received regulatory approval for a new product in December. That product should sustain the company’s double-digit growth for the next few years and the combination of events has led to the share price rising nicely.
It’s also been a great way to beat the market
Filling out a portfolio of companies with above-average yields used to be one of the easier strategies to implement. Traditionally, it’s also been a great way to beat the market as various studies have shown.
But with rates on 10-year gilts below 3%, bond investors have increasingly turned to shares to satiate their appetite for income.
Unfortunately, they’ve also reduced the number of attractive shares available with yields of 4% or more. Such yields are still out there, of course, but from a standing start it’s now more difficult to build a portfolio of high-quality companies with large dividend yields.
Look for a slightly lower yield and high dividend growth potential…
In the current environment, I think a dividend-focused portfolio should start with the high-quality companies with yields near (or even above) 4%. But if few are available, I’d move to a focus on dividend growth.
For example, Unilever and its 3.7% yield fits the high-quality and high-yield criteria perfectly and if you can find others, that’s great. But if you can’t find suitable candidates, I’d favour a yield closer to 3% with strong dividend growth potential, rather than a 4% yield of questionable quality or limited growth potential.
The dividend was increased by 13% and the shares haven’t looked back
I like to think about it like this. If you buy a share for 500p with a 14p dividend you’re getting a 2.8% yield today. If the company can grow that dividend by 10% a year for three years, the dividend will grow to more than 18p and if you hold onto the shares you’ll receive a 3.7% yield on your purchase price.
Companies that can deliver this type of growth generally pay out a relatively small proportion of their free cash flow as dividends. I like to see the dividend below 35% of free cash flow, and the ability to grow cash flow – or earnings – by 5% – 10% a year for three to five years.
This is the situation I saw last May with sandwich specialist Greencore (LSE: GNC), because of its above-average growth potential in the US. At the time, its shares yielded 3.4% and I believed cash flow could grow by at least 10% a year. In fact, the full-year results showed growth a bit better than I had expected as the dividend was increased by 13%. The shares haven’t looked back.
What they all have in common
I like both of these methods for trying to beat the market and believe they work well as long as certain other basic traits are in place. These traits include capable and trustworthy management, an easy to manage level of debt, and high-quality earnings.
With those qualities in place it’s relatively easy to start looking for the companies that fit one of these market-beating strategies.
> Nathan owns shares in Unilever. The Motley Fool has recommended shares in BTG and Greencore. The Motley Fool owns shares of Unilever.