Debunking the Growth Mantra and Getting Real

Roughly two years ago, I ran the following screening exercise on the ASX:

29 April 2014	>20%	>15%	10 to 15	5 to 10	0 to 5	Negative
10 years average Sales/Share growth	65	92	62	64	93	1633
10 years average EPS growth	47	86	57	304	100	1405
10 years average Book Value/share growth	81	128	69	122	112	1513
10 years average DPS growth	22	34	36	41	44	1797
10 years average Operating cashflow/share growth	83	116	50	300	114	1373
ALL	2	5				1156

Total population=2100 companies

Intersecting analysis:

Only 2 companies filled all 5 criteria above 20% per annum: MND, WOR on the back of the super resources boom.

5 companies filled all 5 criteria above 15% per annum: JBH, WOR, RCR, CTL, MND. 0.2%

13 companies achieved both sales and EPS growth above 20% pa for 10 years. 0.6%

28 companies achieved both sales and EPS growth above 15% pa for 10 years. 1.3%

68 companies achieved both sales and EPS growth above 10% pa for 10 years. 3.2%

145 companies achieved both sales and EPS growth above 5% pa for 10 years. 7%

220 companies achieved both sales and EPS growth above 0% pa for 10 years. 10%

(Notice the number roughly doubles as we go down the ranking. These sort of data series follows the power law. Don't ask- no one knows why as yet.)

How about companies able to grow EPS without corresponding growth in sales?

Of 93 companies with less than 5% pa average growth in sales, 38 companies (ie 40%) were able to grow EPS more than 5% pa average,  12 companies grew EPS by more than 10% pa, 9 companies grew by more than 15% pa, and only 3 companies by more than 20% pa.

Of 157 companies with less than 10% pa average growth in sales, 33 companies (21%) able to grow EPS more than 10% pa average,  18 companies grew EPS by more than 15% pa, 7 by more than 20% pa.

Of 219 companies with less than 15% pa average growth in sales, 30 companies (13.7%) able to grow EPS more than 15% pa average,  11 by more than 20% pa.

Higher growth rates in sales appear to reduce ability to increase margins.

204 companies trade above PE 20 as at 30 April 2014. PE 20 roughly implies a growth rate of at least 10% per annum for 10 years and 10x terminal.

The Siren Call of Growth

As of the time of writing in April 2014, I noted that FLN (Freelancer) is trading at a PE multiple of over 615, making it the most expensive stock on the ASX by the measure of price earnings multiple.  I will have to leave the dissection of the business prospects of FLN for another time.  My main objective is to briefly address the issue of “growth” and how it fits within our investing philosophy and framework.

1.       Less than 7% of companies on the ASX achieve compound annual growth in earnings per share of more than 10% per year over periods of 10 years or more. If you remove companies whose EPS figures are distorted by abnormal gains offsetting continual losses, or companies with no consistent earnings, the figure drops dramatically to less than 5%.

2.      However, close to 10% of companies on the ASX are priced for annual compound growth in earnings per share exceeding 10%.  This number does not include loss making companies, which makes up over 66% of the ASX. Clearly, there is presently a divergence between wishes (reflected in pricing) and reality (reflected in historical data).

3.       We need to keep in mind that this distribution is a normal functioning of the market, due to the mysterious workings of power laws.

4.       However, bearing in mind Rule Number 1, we are fearful of Siegling’s Paradox. Whilst sizzling growth rates are always used to justify lofty valuations, many forget that an initial gain of 50% or more is more than wiped out by subsequent losses of similar sizes. For example, you lose all your capital if you gain 100% in the first year, and losses 100% in the second year. You lose 25% of your capital if you gain 50% in the first year and losses 50% in the second year.  As evidenced by the Kelly criterion, bigger risk does not equate bigger gains if you have a scarcity of capital.

5.       Sustained growth is rare and difficult, it requires a confluence of factors- industry tailwinds driving revenue, costs being kept in control, competitors being kept at bay, management not making mistakes, no disruption by technology, no interference from government, no unforeseen events.

Edit: I need to insert a word of caution here on the common but nonsensical use of PEG ratios popularised by proponents of growth investing. The basic idea is to divide the PE ratio by the projected EPS growth to get the PEG ratio. Apparently, anything between 1 to 2 falls within the attractive range. A stock growing EPS at 20% per annum is justified by PE 20, since the PE falls rapidly. To take the logic even further, a stock growing EPS at 100% per annum is justified by PE 100, since 3 years of doubling will bring the PE back to a lowish 12.5. The problem is that the issue of risk is not addressed. A stock growing at more than 20% per annum (let alone 50% per annum) for an extended period of time is a rare beast, as the numbers I have shown above attest to. If I have two stocks, each with a PEG ratio of 1, the first stock at PE 20 projected to grow at 20%, and the second stock at PE 1 projected to grow at 1% per annum, the choice is an absolute no brainer. The absolute irony is that with the second stock, I am getting a 100% per annum yield, assuming all earnings are paid out.

Enjoy and Prosper

Yours One Legged