Education: Aggressive Growth Investing
Incorporating Value into Growth Investing
Value is not a term that is tossed around amongst aggressive growth investors too often, but the concept should not be totally ignored by them. Aggressive growth investors make the bulk of their profits by buying stocks with superior earnings growth that consistently trounce earnings estimates. This is great as long as the company continues to deliver stellar profit growth and keeps raising the bar going forward.
But value is important to gauge the level of investor expectations imbedded in the stock, as well as how far a growth stock could potentially fall if it slips up. In other words, value injects a dose of reality into the equation. So what are some strategies and metrics to incorporate value into aggressive growth investing?
Is the value-conscious growth investor out of luck? The answer is no. GARP, or growth at a reasonable price, is a combination of both value and growth investing: it looks for companies that are somewhat undervalued and have solid sustainable growth potential. The criteria which GARP investors look for in a company fall in between those sought by the value and growth investors. Strong earnings growth is still of utmost importance, but at the same time valuation matters.
GARP investors do not simply buy a portfolio with an equal amount of growth and value stocks. Each stock has to have characteristics of both to qualify.
One of the best known GARP investors was Peter Lynch, who has written several popular books, including "One Up on Wall Street" and "Learn to Earn", and in the late 1990s and early 2000. He is a Wall Street legend due to his 29% average annual return over a 13-year stretch from 1977-1990 as manager of the Fidelity Magellan fund.
PEG Trumps P/E
It is common practice for investors to use the price-to-earnings ratio (P/E ratio) to determine if a company is over or undervalued. However, the PEG ratio is much more relevant to aggressive growth investors. This ratio takes long-term earnings growth rates into consideration, which is vital to the growth investor. For example, a stock trading at 20x earnings with a 10% growth rate is much less desirable than a similarly valued stock with a 30% growth rate.
Lowest PEG Not Always Desirable
As with everything in investing, there are no hard and fast rules with investing. PEG ratios that are too low can actually be riskier than higher ones. Often times, analysts over-estimate the long-term growth rates of many growth stocks, which artificially lowers the PEG ratio. Analysts routinely forecast 35%+ growth for as far as the eye can see, but studies have shown that few companies can sustain this level of growth for too long. So what should the PEG ratio be?
Ideal PEG Between 0.8 and 1.8
Common wisdom says that 1.0 is the ideal PEG ratio, but reality doesn’t quite measure up to that. The S&P 500 sports a PEG of about 1.5. Anything above 1.8 is probably overvalued, while abnormally low ratios carry their own set of risks. As mentioned above, beware of overly rosy analyst predictions of indefinite hyper-growth. Unrealistic expectations are usually priced into those stocks and they can fall hard when these companies inevitably fail to meet these expectations. Take the case of Ebay.
The Example of Ebay
Ebay was a universally loved stock that analysts predicted would grow their earnings over 40% for years to come. This made the stock’s PEG ratio look artificially respectable at about 1.6, but reality was introduced into the equation when the company failed to beat the high bar. For the quarter ended 12/04, Ebay merely met estimates and the stock plummeted from $51.53 to $41.67 per share, and this was after they met estimates! The point is to beware 35%+ growth projections that never end.