Getting to grips with growth shares
By William Meyer – Fenestra Asset Management
Growth shares are companies which are expanding and whose earnings are growing faster than those of other companies or listed companies in general.
Typically, these companies have dynamic management, a niche market, a new invention, new technology or a special service. They are often smaller companies. As Jim Slater says in his book the Zulu Principle: “Generally speaking elephants don’t gallop.”
Significant appreciation in share price
It is in shares of this type of company that very large profits can be made. The profits come from two sources: higher earnings and the willingness of investors to rate these companies as superior. To put it another way, higher earnings and a higher earnings multiple will result in significant capital appreciation in the share price.
And where should you look for these companies? Well, they’re often smaller than the leading shares or blue chips. They may be worth less than R800 million.
Aggressive management teams
These smaller companies are not analysed and followed by the big institutions, so this is an area where the small investor has a distinct advantage. This is an area where one finds aggressive management teams on a mission. As Peter Lynch, the author of One Up on Wall Street says: “If you choose wisely, this is the land of the 10 – to 40 baggers, and even the 100 – bagger. With a small portfolio, one or two of these can make a career.”
Obviously explosive profits can be made if you pick a small company growing organically and by acquisition in a business sector that is also on a growth trajectory, but it does not have to be like this.
A new company with a disruptive technology in a mature industry can also be a brilliant investment. Add driven management who are well resourced with the necessary processes and vision and you may have found a winner. These companies steal market share from more mature and complacent competitors.
Generally the hotel business in mature economies grows at only 2% a year but sometimes a hungry upstart in this industry can grow at 50% a year by devouring competitors’ market share.
Look what City Lodge did to the hotel industry in South Africa. Hans Enderle came out of nowhere with one hotel and look where they are now.
La Quinta Motor Inns did the same thing in America.
Think of how many South Africans saw the launch of City Lodge and how few decided to invest in this upstart company. And City Lodge has been a phenomenon!
Not underfinanced and not overtrading
It is very important to include in your study whether or not these companies have scalability e.g. if the first hotel is a huge success will the next one at another location or in another country also be profitable. If the answer is a resounding yes, then the stock price is bound to go higher.
You must check that the company is not underfinanced and is not overtrading. Also, a fast growing company that is highly rated and which then disappoints the market will be repaid with a collapsing share price.
The most important point of this article is to note that a stock’s price is basically in harmony with its long-term earnings growth rate. And it is accelerating revenues and earnings and proprietary products in a rapidly expanding market that will propel the stock higher. The basic philosophy is that share prices follow the earnings trend and the trick is to see these earnings coming before the general market does. Pick the best potential earnings growth.
As long as these stocks can keep providing positive earnings surprises they will keep adding profits to your portfolio. Stick to the stocks you believe in, understand them thoroughly, stay committed and don’t let others shake you out of your positions. The final trick is to figure out when they will stop growing and whether or not you are now paying too much for a declining growth trend!
If you are not happy with your portfolio performance or would like a second opinion, please do not hesitate to contact Fenestra for a confidential consultation.
** William Meyer is a qualified Chartered Accountant (CA) and Chartered Financial Analyst (USA). He has been CEO of Fenestra Asset Management since 1990. He lives in Mooi River with his wife Claire and their four children. He commutes to his head office in Cape Town.