Two men enter the office of an insurance company. One of them is 32 and the other one is 84.
They are both looking to buy a life insurance
Who do you think will have to pay the higher premium?
That's absolutely correct - it would be the 84 years old
The risk of him dying in the common years is much higher than the 32 year old
Corporations have life cycles, just like humans do. Risk increases when maturity is reached.
And therefore, in this video, we will learn how to identify companies that are in a strong growth phase, rather than
maturity or decline, as this is a top 5 takeaway summary of Picking Growth Stocks
Written by the "father of growth investing" Thomas Rowe Price Jr.
This is The Swedish Investor, bringing you the best tips and tools for reaching financial freedom through stock market investing
Takeaway number one: Form an objective
Let's introduce three different characters
Growth Gregory is 27 years old
He graduated from college a couple of years ago and
has just been promoted from his entry-level position at an international manufacturing company
He learned about the stock market quite recently and has concluded that without having to quit his job and become an entrepreneur,
it's one of the best opportunities for him to reach financial freedom. If he is going to work until the traditional retirement age of
65-something, it's going to be because he loves what he's doing, not because he feels forced to do so for financial reasons
Cash flow Charles has just retired at age 67
Charles has been saving part of his income during his whole career, and has managed to build up quite a fortune
which is now planning to live off
He's healthy and not intending to have his "ultimate retirement" until he reaches at least three digits of age
So he'd like for his capital to last as long as possible
Baby Brittany and her husband Toddler Tony are about to expand their little family from two two three and in about two years
they think it will be necessary to upgrade from their current city apartments into a house in the suburbs
They've been renting up until this point, which means that the cash for the house must come from their income
They've been saving for
quite a while, but still need a bit more to be able to afford the house that they've set their eyes on
When you are investing, it's important to always have your main objective in mind
Usually it boils down to one of the following three
- Capital conservation
- Liberal income; or
- Capital growth
Which objectives do you think that Gregory Charles and Brittany have?
Gregory is looking for capital growth, Charles for liberal income and Brittany for capital conservation
Now, a market investment or security can do one of these objectives well,
but it often means sacrificing the other two
Short-term bonds of high-grade or bank deposits are great for capital conservation,
but they are completely useless for income or capital growth
Preferred stocks, bonds of slightly lower grades and
some types of common stocks, are useful for the investor who is looking for liberal income, but not so much for capital conservation or capital growth
Finally, most growth stocks are really well suited for capital growth, but not for capital conservation or income
Since you are watching this channel
I assume that you aren't at the stage of Charles just yet and
since capital conservation is simple and quite boring,
let's focus on finding stocks to aggressively increase the value of your portfolio, like Gregory aims to do, in the next four takeaways
Takeaway number two: The life cycle theory of investing
Corporations have life cycles just like humans do - risk increases when maturity is reached
Therefore, we'd like to pick up a company in its growth phase rather than in the maturity or declining one
First and foremost, we want to look at the industry
The two best measurements to see where in a cycle a specific industry is, is by looking at sales
(measured as unit volume) and net earnings available for shareholders
The two variables are
somewhat correlated but typically net earnings start to fall much faster than sales once maturity is reached
due to competition and prior capital investments
Companies are desperate to keep their market shares, so they keep producing at full manufacturing capacity, which results in a bloodbath
Therefore, you want to own stocks in industries that show growth in both unit volume and net earnings
But sometimes it's difficult to separate an industry life cycle from a normal business cycle
We want to identify the so-called secular (or underlying) trend, but actual sales and profits of an industry typically
oscillates around the underlying trend because of many outside factors that are just distractions
In takeaway number four and five, we will try to separate the signal from the noise
Price argues that for stocks in a growth phase, the chance of profit is higher and the risk of capital loss is lower
Okay, that's pretty much the theory behind it. Now, how do we proceed to find these growth stocks in practice?
Takeaway number three: Identifying growth stocks
Price definition of a growth stock is:
"Shares in a business enterprise which have demonstrated
favorable underlying long-term growth in earnings and which, after careful research study, give indications of
continued secular growth in the future
There are two different types of growth stocks: stable and cyclical ones
Those that have only minor fluctuations in earnings and dividends during times of turmoil are stable, and vice versa
Think a Disney vs. a Volvo (the Swedish truck manufacturer)
Moreover, growth stocks can be either of the first grade or of the second grade
First grade growth stocks are typically leaders in their fields,
established companies which show financial strength
Second grade growth stocks are pretty much the opposite -
unseasoned, often dependent on a few or a single type of products or patterns and financially weak
Let's go through Thomas Rowe Price Jr.'s qualifications for each of the quadrants
First grade stable growth socks must show four quantifiable qualities
Disney fulfills these criteria quite well
But that's not enough to say that Disney would have qualified as a growth stock that Price would have bought, just yet
There's also a future component built into this
We must be expecting, based on qualitative factors that we will go through in takeaway number four and five,
that both earnings and dividends will be higher in the coming years too
Second grade stable growth stocks should have the same qualities, if I'm interpreting Price correctly,
but I have to admit that it's a little bit vague in the book
I think that the only difference between the two groups are the aforementioned factors of being a seasoned player in the industry
and the financial conditions
The Swedish company BioGaia qualifies quite well here, but it does have a strong balance sheet
On to the cyclical growth stocks. A first grade one should fulfill the following:
I would argue that, at least while keeping the component of the future out of it, Volvo qualifies as such a stock
Both the earnings and the dividends from the last period of prosperity, the one before the financial crisis, has been surpassed in
2018 and 2019
If this trend can continue into the future is a different story, and for that, we'll need to understand the next two takeaways, but finally ...
A second grade cyclical growth stock should show the following premises:
And as you can see, this quadrant is almost entirely decided by qualitative factors
You'll have to take this with, not just a grain of salt but probably a whole bowl full of it,
but at a first glance, I think that Tesla qualifies for this quadrant
It's cyclical - just like any other car manufacturer -
it's definitely dependent on a single product or type of product,
it has weak financials,
but there's a strong demand for the cars and the brand value is high
Also, the revenue is increasing like crazy
If we go back to the objectives presented in takeaway number one; different types of growth socks can take on different roles
Stable growth stocks of the highest grade can qualify for liberal income, while timing second grade cyclical growth stocks
well gives the best opportunity for capital growth
Now, on to the qualitative factors
Takeaway number 4: Factors causing strong growth
Alright, so we want to identify stocks that are in a growth phase, rather than a maturing or declining one. Here are six indicators
improving the odds that the stock is still in a growth phase:
It's a leader within an industry
The company doesn't necessarily have to be dominating a broad industry, such as that of car manufacturing. Being the dominant player of a niche,
such as electrical car manufacturing for the upper-middle class, can be just as good
Valuable patents
This is a simple way to lock in profits for a period of time
Beware expiration dates if this is important to the company though
Experienced staff
It's been said that: "The greatest asset of a company is its people"
While some companies measure their percentages of employees with college degrees,
I think it is more important to look for satisfaction among employees
Glassdoor is a pretty good tool for this
Capable and progressive management
Hello Tesla!
For a company to keep growing it must stay competitive, and a progressive management is definitely key to this
Potential to reach a world market
if there's still a lot of untapped potential from a geographical standpoint, that is great. When Warren Buffett began to purchase Coke in
1988 he noted that Americans were drinking, on average,
289 bottles of Coke per year while in many other countries the consumption was far lower
Maintaining profitability while increasing sales
This is usually referred to as
"scalability" and it's a very important trait for a growth business
What you typically want to look for are
companies that can add an additional customer at a price which is lower than the average of acquiring their previous X number of customers
Many companies with digital products fulfill this
Takeaway number 5: Factors causing maturity and decline
Charlie Munger, Warren Buffett's, right-hand man says: "Invert, always invert"
Now we're going to listen to Munger's advice:
Which indicators decrease the odds that a stock is still in a growth phase and probably reveals that it has reached maturity?
Adverse changes in management
There are tons of reasons of why a single person may want to switch jobs,
but if there's a drastic turnover in the senior management, it's likely a problem with the culture or with the prospects of the business
Saturation of markets
Quite self-explanatory.
if the company is dependent on only one or a few products and there seems to be a
stagnation of the demand of these across all possible markets, it is a really bad sign
New inventions and obsolescence
Many large and successful companies have been destroyed by new innovations
Kodak got annihilated by digital cameras. Nokia was crushed by smartphones. And Xerox disappeared in a digital world.
Increased competition
Similar to the last point, but sometimes an industry doesn't have to become obsolete to turn unprofitable
Sometimes it's just enough that everyone wants to be doing the same thing
Adverse legislation
I've mentioned the Swedish gambling company Betsson as one of my worst investments ever and
although he checked many of the other boxes from this takeaway as well, such as increased competition,
an unfavorable regulation in 2019 really turned out to be the nail in the coffin
Increased taxes, a ban on certain types of marketing, and an increased ability for customers to control their own
gambling behavior, will surely lead to a stagnation or at least a sharp decline in the growth of the gambling industry in Sweden
Which may be a good thing ...
Just not so much for my wallet
Rapidly increasing costs
The earnings of the aviation industry is affected by the price of oil
Manufacturing companies are affected by the price of commonly used metals such as steel aluminium and copper
And, of course, the earnings of any firm largely depends on the price of labor within that specific industry
At times, a single one of these factors can cause a secular trend to halt
At other times it's a combination of multiple effects, which are to blame
Now, I know that you might be thinking:
"Well, what about the price of the business? Isn't that a factor to consider before buying too?"
An investment strategy that focuses more on the purchasing price is offered by Benjamin Graham and his value investing
It's pretty much the polar opposite of Thomas Rowe Price Jr.'s strategy of finding growth stocks
Here's a playlist of books of the legendary Benjamin Graham so that you can compare the two methods and
learn which one that suits you best
Cheers guys!