Are Growth Stocks A Viable Option For Retirement Portfolios
IntroductionThere are two important phases that people should consider when investing in equities to fund all or part of their retirement. First there is the accumulation phase, representing the time when retirement is still many years away. But once retirement is taken, you enter the distribution phase when you need to start taking distributions from your portfolios. In theory, investors in the accumulation phase might logically be more concerned with maximizing total return. However, once in the distribution phase, current income tends to become the focal point.
In principle, this brings up some very important questions. Should investors in the accumulation phase simultaneously be more aggressive with their equities, or should investing for retirement always be approached as conservatively as possible? As it is with most financial concepts, the answer is it depends on the individual’s own unique needs, objectives and risk tolerances. Moreover, the amount of capital available for investment could also be an important factor regarding what strategy you might choose or need to implement.
This brings me to a few comments on what has become a long running debate, or even war, between Fred Perry Outlet dividend growth investors and total return investors. Frankly, I think the arguments border on the ridiculous, because in my way of thinking both are and/or can be viable choices. As I stated earlier, it really depends on the individual, and the strategies they are most comfortable with. Therefore, I find it hard to understand why the discussions become so heated.
However, regardless of which method you choose, I feel it’s important that the investor has a clear handle on the advantages, disadvantages and risks associated with either strategy. In part one of this two part series I discussed the important principle that not all stock price drops are the same. This applies equally to both investment strategies, total return (growth oriented) and dividend growth (income oriented). However, in part one the majority of what I wrote was oriented to the dividend growth investor. Here in part two my focus will move to investing for total return or investing in more growth oriented common stocks. As previously stated, I do not believe that one is necessarily better than the other, or that one strategy is right and the other wrong. However, they are different for sure, and as a result have different types and levels of risk and reward associated with them respectively.
Therefore, one of my primary objectives with both articles in this series is to highlight some of the more important differences, and present both a few rational tactics and a clear awareness regarding what I believe it takes to succeed in either. In certain aspects, the differences are subtle, but in other areas profound. In other words, I support both approaches as long as the investor is fully cognizant of the risks, pitfalls and rewards of whichever strategy they choose to use. Personally, I utilize and covet both of these approaches investing for total return, and dividend growth investing.
I like them both, but for different reasons, and I incorporate them both at different levels, and I always have. When I was younger, I had more growth in my portfolio, now that I am more mature, I hold more dividend growth investments. Most importantly, I don’t argue with myself over which I feel is best. Instead, I recognize that both offer unique advantages, and both contain significantly different levels of risk. However, when I do assume more risk, I also expect more reward as a result, but sometimes risk bites you where it hurts. The rational investor should be prepared for those times when risk rears its ugly head. The best tactics are proper diversification and continuous monitoring and rigorous ongoing research.
Precisely Defining the Term: Growth StockBefore I go any further with my discussions about investing for growth or total return, I think it’s extremely important to define my terms. I take this position because experience has taught me that the financial industry is often very vague regarding how they define things. I believe that for true understanding to occur, we must be very precise with how we define the things we are attempting to analyze. Therefore, let me start with a few examples of how the finance industry defines a growth stock.
From InvestorWord’s website I found this definition of a growth stock:
“Stock of a company which is growing earnings and/or revenue faster than its industry or the overall market. Such companies usually pay little or no dividends, preferring to use the income instead to finance further expansion.”
I consider this a good start, but still a little vague. Investopedia explains a growth stock as follows:
“A growth stock usually does not pay a dividend, as the company would prefer to reinvest retained earnings in capital projects. Most technology companies are growth stocks. Note that a growth company’s stock is not always classified as a growth stock. In fact, a growth company’s stock is often undervalued.”
To me, the Investopedia explanation is also vague, and additionally conflicting. This iteration indicates that an attribute of a growth stock would often be associated with undervaluation. This seems to be in conflict with academics such as Eugene Fama and Kenneth French who contend that growth stocks have high price to book ratios, and further contend that a growth stock is one that investors are willing to pay a high price for now, to stake a claim of what they expect will be exceptional future growth. To me, this academic definition implies that growth stocks tend to be overvalued.
Consequently, and for the purposes of this article, I define a true growth stock as follows: in order for me to consider a stock a growth stock, the company must have a history of growing their earnings in excess of 15% per annum, while simultaneously possessing a forecast expected future growth rate of at least 15% or better. The primary point that I wish the reader to glean from my definition is the focus on the growth of the business being the primary determinant qualifying it is a growth stock. To be clear, my definition of a growth stock would be more precisely stated as a growth company or business.
Still, even with my precise definition requiring a minimum 15% per annum earnings growth rate, there are lower rates of earnings growth that can also be technically referred to as growth. For example, a company that is growing earnings at rates of 5% per annum or less could be more precisely defined as a low growth stock. However, even such low growth is nevertheless growth. Then there would be faster growing companies that grow their earnings from 5% to 15% per annum that could be defined as moderate growth stocks, etc. Additionally, there also exists super fast, or what I also think of as hyper fast growing businesses with long histories of earnings growth above 15% per annum. In other words, there are many faces of growth.
For purposes of this article focusing on total return investing, I will be reviewing companies that meet my minimum earnings growth rate of 15% or better. However, I will also include examples of companies that fall into the super fast or hyper fast growth stock categories. In so doing, my objective is to bring to the reader’s attention the incredible opportunities that total return, or growth investing, potentially offers. Conversely, my additional objective will be to highlight the greater risk that investments in these high growth categories also possess. Graphs research tool and provide various examples of true growth stocks to include a few examples of hyper growth stocks. Since a picture is worth a thousand words, I will let the earnings and price correlated graphs with performance reports speak for themselves. However, with each example there are a few key focal points that I suggest the reader reviews.
First of all, look to the FAST FACTS boxes to the right of each graph and note the historical operating earnings growth rate on each example. Since these are all examples meeting my strict definition of a growth stock, the P/E ratio of the orange earnings justified valuation line will be equal to the company’s operating earnings growth rate. In other words, each graph in this series is drawn utilizing the P/E = Earnings Growth Rate formula.
Next, I ask that the reader focus on the capital appreciation that each example achieves and how it closely correlates with the company’s historical high earnings growth rate. This supports my long standing contention that the rate of change of earnings growth determines capital appreciation. The idea is to gain a perspective on the performance power (total ret Fred Perry Outlet urn) that investing in growth stocks can provide. To add further insight into this important principle, I will turn to Peter Lynch and one of his 20 Golden Rules:
Fred Perry Outlet “Often, there is no correlation between the success of a company’s operations and the success of its stock over a few months or even a few years. In the long run, there is a 100% correlation between th Fred Perry Outlet e success of the company and the success of its stock. This disparity is the key to making money; it pays to be patient, and to own successful companies.”
Simultaneously, I believe that the careful examination of the graphics also reveal the risk associated with achieving high capital gain generated total returns. Achieving a high rate of earnings growth over an extended period of time is both difficult and rare. Moreover, I will cite a few examples illustrating the reality that exceptionally high growth tends to diminish over time. This is an important risk that all total return investors should keep at the forefront of their minds. Graphs research tool functions, I offer the following explanatory link.
Deckers Outdoor Corporation: (DECK)Deckers Outdoor Corporation operates as a designer, producer, marketer, and brand manager of footwear, apparel, and accessories. The company’s footwear appeals to men, women, and children.
With this first example, I start out by providing a graph of earnings only for Deckers to focus the reader’s attention on the operating success this company has achieved since 2001. This company reports earnings on a calendar year end fiscal basis, and their only blemish was 2012. Nevertheless, operating earnings growth of 20.1% exceeds my 15% minimum threshold. More importantly, this earnings growth rate is almost 4 times higher than the 5.3% average earnings growth rate of the S 500 index.
(click to enlarge)
Next, by overlaying monthly closing stock prices (the black line) over the orange earnings justified valuation line, important information is revealed. First of all, we see that stock price ultimately goes where earnings go over the long run. But, we also see shorter periods of time where price disconnects from its earnings justified valuation. Therefore, when we examine performance (capital appreciation) since 2001 we discover that long term shareholders of this high growth company received a powerful annualized return.
But, from a careful examination of stock price (the black line) we also find an example that vividly reveals the risk associated with achieving those high returns. The reader might ask themselves the following introspective questions. Could I have handled the significant price drops that occurred in calendar years 2005 and 2008 (the Great Recession) even though earnings continued to grow? Could I have further stayed the course when earnings fell by 29% in calendar year 2012 which led to a horrifying and precipitous drop in stock price?
Frankly, since most investors focus on stock price instead of operating results, I contend that few could have held on long enough to reap the rewards that investing in Deckers Outdoor Corp offered. Investing for high total return based solely on capital appreciation will test the nerve of even the most seasoned investors. Herein lays one of the greatest risks facing the total return investor. Stock price can not only be quite volatile, but also capriciously fickle at the same time.