Future of Growth Investing

The epitome of growth investing was the one-decision stock era of the bull market of the early 1970s. The notion was that growth of earnings per share could be projected as a straight line on semi-log paper for the most durable, well managed companies. Predictable growth would be valued richly by investors, which would make equity capital cheaper and easier to raise. In turn, this equity could be invested at higher than average rates of return on capital, which cycled into more earnings per share. And so the money machine would turn. The proper investment strategy was to buy the right companies and hold them forever.

The index funds of the late 1990s get some of the same influence although not by overtly selecting highly regarded stocks (see Indexing and Mutual Funds). But the index tends to be more heavily weighted in those stocks. The one-decision phenomenon of the 1970s and the indexing craze of the 1990s may end up at the same place: ownership of a handful of richly valued companies whose history is not a precursor of their future. And the indexer, like the one-decision investor, is disciplined to stay invested no matter what.Jeremy Grantham of Grantham, Mayo, Van Otterloo & Co. LLC comments:

Historically, at the stock levels in the United States, equity investors have over-paid for comfort (stability, information, size, consensus, market domination, brand names). Historically, equity investors have over-paid for excitement and sex appeal (growth, profitability, management skills, technological change, cyclicality, volatility, and most of all, acceleration in the above).

Paying-up for comfort and excitement as growth managers do for example, is not necessarily foolish, for clients also like these characteristics. Conversely, when a value manager is very wrong as he will be sooner or later he will be fired more quickly than a growth manager. To add insult to injury, the data indicates that the best growth managers add more to growth than the best value managers can add to value, probably because the fundamentals and the prices are more dynamic for growth stocks.

Finally, beyond the financial details of potential growth companies and growth stocks, what are the broad requirements of a successful business? And conversely, what are the features of business failure? We suggest three characteristics which, if found together, will guarantee success for failure. If a business has a combination of passion, authenticity and integrity, it will succeed. In contrast, whenever you find together the three ingredients of mediocrity, arrogance and isolation, the business or indeed the country concerned will fail.

Critics on Peter Lynch

Why not? Of course, the purpose of equity investing is growth, is it not? So the two words seem to be inseparably linked. But perhaps we confuse growth with appreciation. And perhaps we automatically associate past growth with future appreciation. They can differ.

Marc Faber, our guru for Manias, Panics and Crashes, points out, there are two reasons why highly popular stocks, which have become viewed as growth stocks, usually end up as costly disappointments:
First, exciting new markets often fail to keep growing as rapidly and profitably as expected. Second, when a business achieves great success, competitors are attracted into the field, slowing growth and shrinking profit margins for the early leaders. Gottaown stocks are very likely to be losers.

Certainly, when growth stocks start to decelerate, when momentum ends, the price of failure is high. Once a growth stock starts to fall, it loses its momentum attractions, followers of the trend start to desert, forcing the price down further and creating a downward spiral. In such circumstances, there can be high penalties for earnings disappointments. Eventually, growth stocks fail to fulfill their original promise and disappoint investors. Then, as fallen angels they become potential seeds for future value stocks.

Some growth industries never produce any growth stocks: competition is so fierce that no one makes any money. And in a classic article published in the Harvard Business Review over 40 years ago, Peter Bernstein (see Economic Forecasting), makes the important distinction between growth stocks and growth companies:

Growth stocks are a happy and haphazard category of investments which, curiously enough, have little or nothing to do with growth companies. Indeed, the term growth stock is meaningless; a growth stock can only be identified with hindsight it is simply a stock which went way up. But the concept of growth company can be used to identify the most creative, most imaginative management groups; and if, in addition, their stocks are valued at a reasonable ratio to their increase in earnings power over time, the odds are favorable for appreciation in the future.

While Peter Lynch likes growth companies, out of self-professed lack of understanding, he has tended to avoid the high-tech area, where many of the biggest individual growth stock gains of the 1990s have been made (see Internet Investing). His style is also limited to investing in US equities. Of course, it is true that the concept of investment in growth companies as a distinct style of equity investing seems to emerge only in maturing economies. Growth is assumed to be an integral element of any stock selection criteria in many other parts of the world

Peter Lynch, Growth Investing Expert

Peter Lynch is one of the best-known names in investing. He ran Fidelity's Magellan Fund for thirteen years from 1977 and in that period, Magellan was up over 2700%. Lynch managed a vast portfolio, containing over fourteen thousand stocks at any time, and turned over the whole portfolio on average once a year. Yet even in difficult markets, he was almost always opposed to assets sitting in bonds and cash. Instead, he advocated holding good quality stocks with low volatility when going defensive.

Lynch's basic message is that an individual investor can actually find great stocks before Wall Street does: using a combination of intelligence, reflection, perseverance and discipline, it is possible for the average person to uncover great investments. His central point is that products and services you use and enjoy are often provided by excellent companies. If you research these companies and find out whether or not the stock that corresponds to them is priced favorably, you have an outstanding chance at compounding market-beating returns industries and businesses; investigating how a company treats its customers and vice versa. This is the only way I know to find great companies, and nothing beats the feeling when it pays off.

While a fund manager is more or less forced into owning a long list of stocks, an individual has the luxury of owning just a few. That means you can afford to be choosy and invest only in outfits that you understand and that have a superior product or franchise with clear opportunities for expansion. You can wait until the company repeats its successful formula in several places or markets (same-store sales on the rise, earnings on the rise) before you buy the first share.

If you put together a portfolio of five to ten of these high achievers, there's a decent chance one of them will turn out to be a ten-, a twenty- or even a fifty-bagger, where you can make ten, twenty or fifty times your investment. With your stake divided among a handful of issues, all it takes is a couple of gains of this magnitude in a lifetime to produce superior returns.

So what advice does Lynch give to the typical individual investor? Writing in his regular column in Worth magazine, he recommends:

Find your edge and put it to work by adhering to the following rules:

With every stock you own, keep track of its story in a logbook. Note any new developments and pay close attention to earnings. Is this a growth play, a cyclical play or a value play? Stocks do well for a reason and do poorly for a reason. Make sure you know the reasons.

Pay attention to facts, not forecasts.

Ask yourself: what will I make if I'm right, and what could I lose if I'm wrong? Look for a risk-reward ratio of three to one or better.

Before you invest, check the balance sheet to see if the company is financially sound.


Don't buy options, and don't invest on margin. With options, time works against you, and if you're on margin, a drop in the market can wipe you out.

When several insiders are buying the company's stock at the same time, it's a positive.

Average investors should be able to monitor five to ten companies at a time, but nobody is forcing you to own any of them. If you like seven, buy seven. If you like three, buy three. If you like zero, buy zero.

Be patient. The stocks that have been most rewarding to me have made their greatest gains in the third or fourth year I owned them. A few took ten years.

Enter early but not too early. I often think of investing in growth companies in terms of baseball. Try to join the game in the third inning, because a company has proved itself by then. If you buy before the line-up is announced, you're taking an unnecessary risk. There's plenty of time (ten to fifteen years in some cases) between the third and the seventh innings, which is where the ten- to fifty-baggers are made. If you buy in the late innings, you may be too late.

Don't buy cheap stocks just because they're cheap. Buy them because the fundamentals are improving.

Buy small companies after they've had a chance to prove they can make a profit.

Long-shots usually backfire or become no shots.

If you buy a stock for the dividend, make sure the company can comfortably afford to pay the dividend out of its earnings, even in an economic slump.

Investigate ten companies and you're likely to find one with bright prospects that aren't reflected in the price. Investigate fifty and you're likely to find five.

What Is Growth Investing?

Growth investing is one of the two classical styles of investment. There are numerous different definitions of the style and some confusion about the precise relationship between growth companies and growth stocks. But a focus on growth is generally contrasted with value investing, which tends to rely more on quantitative methods of analysis. Growth investing tends to be based more on qualitative judgments about the kind of companies that will offer remarkable growth rates and exceptional returns performance.

Growth stock investing arose as a definable concept in the United States of the 1930s the counterpoint to the safe, secure income investing of the depression years. It was presumed that companies with a past record of growth in revenues and earnings had the momentum to carry them into the future. And they had to go farther into the future or at greater rates of growth than the market had already accorded in its discounting through current prices. T Rowe Price, who first set out the principles of growth stock valuation in the 1930s, wrote:

Growth stocks can be defined as shares in business enterprise that have demonstrated favorable underlying long-term growth in earnings and that, after careful research study, give indications of continued secular growth in the future.

In order to turn a capital commitment into appreciation, the growth investor needs prescience about earnings or rate of growth or the market's willingness to pay for future events. At certain times in the market for example, in the late 1960s and early 1970s and, more recently, in the late 1990s the growth investor has been rewarded with handsome returns. Those returns have in part been the result of an increase in the number of growth investors rather than a change in the valuation systems used by an existing population of investors.

And the agreement runs backwards in that those equities that have appreciated are assumed to have growth characteristics. Almost any list of the best managed companies a popular and recurring article in business publications will be composed of those stocks that have had an unusually favorable price performance for some past period. Growth stocks may see the future through the rear view mirror.

Future of Global Investing

Recent research indicates that Americans are more likely to invest in their local regional Bell operating company than in any other. Considering that everyone's local operator cannot be a better investment choice than any of the other six, this finding suggests the importance of investors' psychological need to feel comfortable with where they put their money. Perhaps it relates to the endowment effect, a phenomenon noted by behavioral finance, where people set a higher value on something they already own than they would be prepared to pay to acquire it.

But if people still do have a predilection for investing in familiar stocks, they are likely to leave largely unexploited international investment opportunities and hold sub-optimally diversified portfolios. It is tempting to conjecture that such a psychological attitude might be even more pronounced in the highly diverse cultural contexts of European countries. Such an attitude could explain the lack of cross-country portfolio investments within Europe, and suggest that the internationalization of European individual portfolios will be a slow process even in the wake of the euro.

On the other hand, the potential development of a European identity and the increasing tendency to think European rather than French or German a tendency that is likely to be enhanced by the advent of a shared currency could make European investors less reluctant to hold equity stakes in companies residing in a European state different from their own. Perhaps European home bias will fade.

Of course, none of the reasons for home bias apply to the individual global investor with the funds, access to broking services and time to conduct research on the opportunities in the international equity market. It seems likely that home bias and low market correlation will diminish over time as the interconnections of the global economy become closer and the confidence of investors in overseas markets grows. But in the meantime, by leaving some lower risk and higher return possibilities relatively unexplored, they might help an investor to formulate an international investment strategy that can beat the market consistently.

There is also now a vast amount of information on global investment opportunities available on the internet. Any point on the globe is as accessible as next door. It is cheap and often free. It shifts control of time, depth of information and source to empower the user. And it is open: anyone can come in taking its knowledge and offering skills. Financial centers are described on a satellite connection, not geographic coordinates or proximity to other financial talent centers. Work takes a different form in time and space with email, videoconferencing and the internet, all of which are available at a price for the single user at his or her own site. Location becomes irrelevant.

A visit to South Africa from the United States, for example, requires probably a week of preparation, a week there, and a week of decompression on the other side a total of three weeks, assuming we are efficient. Compare that with a day on the internet. How much information could one get on South Africa in the course of a few hours on the web? The information might be different, but it is going to be a large volume in a short period of time. You would understand the culture and the issues, and you could gain a lot of information that is hard to find out otherwise.

According to that well-known fan of investment management, Bill Gates: ''Anyone who is not intimately involved with the internet and the web does so at extreme peril." This statement applies with particular force to investment analysts and private investors. For those of us who are dedicated to moving our craft forward, being ahead of others and using the best tools available, the internet is our mandate.

Critics on Gary Brinson' Theory

If global investing is superior to investing in only one market, why do so many investors hold disproportionate amounts of their portfolios in equities of their own domestic markets? Even sophisticated institutional investors, such as pension funds and insurance companies, tend to concentrate well over three-quarters of their equity funds in domestically quoted shares, a phenomenon known as home bias. Evidence of wide discrepancies between national market performances over certain periods of time suggests that these investors would maximize their returns and minimize their risks more effectively by diversifying more fully across stocks in different countries.

Various explanations for home bias have been advanced. These include IMF officials' arguments that it is, in large part, due to the substantial risks of adverse exchange rate changes, which cannot be guarded against with standard hedging techniques. Currency risks may be compounded by the different supervisory environments in particular markets, by fears that capital controls may be instituted, by taxes on international trading or simply by a wish to avoid the time and expense of maintaining and researching a more widely spread international portfolio.

Such reasoning is supported by arguments that the benefits of international diversification arise merely from the fact that different stock markets have their shares concentrated in different industries. For example, the UK privatization program of the 1980s means that utilities are a more important part of the London market than elsewhere. Similarly, investment in the Swiss market implies a disproportionate bet on banking stocks, and investment in the Swedish market a commitment to basic industries. The implication is that global investing offers nothing more than exposure to additional industries.

Yet home bias on the part of institutional investors seems to be more a result of government restrictions on the amount of foreign assets pension funds and insurance companies in any given country are allowed to hold. It also may arise from the way in which fund managers' performance is assessed through reference to a local market index: even if passive indexing is not their dominant strategy, there is inevitably a strong incentive to own a good slice of the index's components. And industry analysts are often more prevalent than country analysts in fund managers' offices, suggesting a disposition to choose industrial over international diversification.

There is evidence that the covariances of global markets may be sliding closer, though Japan may be a special case. For the other members of the G-7, coordinated banking policies and facilitated information flows should tend to drive markets into a more steady alignment. On the surface, such an increase in stability could be seen as beneficial for business but would be a lessened benefit for portfolio investors attempting to diversify risk.

For example, closer links between European economies following the introduction of the euro will increase the incentive for US investors to diversify into European markets. At the same time, this may also strengthen the relationship between different European stock markets, reducing the incentive for diversification within Europe.

Gary Brinson an Expert on Global Investing

Gary Brinson is a staunch advocate of asset allocation techniques and a pioneer of global investing. In 1974, the firm now known as Brinson Partners (then a unit of First Chicago) was one of the first to invest overseas. Brinson led a management buyout of the unit in 1989 and the firm was later acquired by Swiss Bank Corporation. The latter has since merged with Union Bank of Switzerland and as a result, Brinson directs over $300 billion in institutional assets, making it one of the world's largest money managers. Brinson is also co-author with Yale finance professor Roger Ibbotson of a book about asset classes, investment theory and international investing.

The Swiss banks were interested in Brinson Partners for its money management business but perhaps even more for its ability to bring North American investment techniques to Europe and elsewhere in its network. Features that are taken for granted in the United States like performance measurement, incentive compen sation, quantitative tools and hedging are less familiar in Europe (see Performance Measurement, Quantitative Investing and Risk Management). At first, the relationships were rather loose with interns coming to the Chicago headquarters for training and management coordination with the Swiss management largely by encrypted videoconferencing. More recently, the risk management and tighter controls at headquarters have dictated closer ties.

Brinson has promoted the professionalism of investment management by taking an active part in its industry association, the Association of Investment Management & Research (AIMR) and its Research Foundation. He is an advocate of small, steady incremental gains in improvement of standards. Similarly, he is an advocate for small changes in asset allocation. Consistent with the Swiss style of investing, major swings are generally unlikely to take place.

Brinson argues strongly that investment decisions should focus first and foremost on markets or asset classes since that explains roughly 90% of returns. The key is to consider overall portfolio risk rather than the risk of individual assets: a sound asset allocation combines diverse asset classes in ways that increase returns without an equal increase in risk or reduce risk without sacrificing returns.

His global asset allocation strategy rests on four basic principles:

• Think global.
• The value of asset classes should not rise and fall together.
• Focus on the long term.
• Monitor and adjust allocations to accommodate changed investment climates.

Brinson believes that in a relatively short time, it will seem as odd to most investors to discuss a Europe fund's country allocations as it does now to discuss a US fund's relative exposure to each of the fifty states. In his mind, country concerns will be minimal in comparison with company concerns.