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Using Growth and Value for Stock Selection

July 09, 2014

Value investors come in all shapes and sizes. From the Ben Graham followers who look at book value or underlying tangible net asset worth to those who apply a value mindset to work in other ways, including earnings growth. I fall into the latter category.

Value purists will say that forward earnings are not tangible so should be used sparingly. That’s fine, there are some very successful investors who rely mainly on tangible assets to make their value approach work. One of the most important traits to being a successful investor is to use an approach that works for you. For me, I can’t ignore that the lifeblood of a business is its earnings and this has a very direct effect on valuation. The trick is to find those where earnings are growing in a reliable and healthy way while not overpaying for such earnings.

Some call this a Growth At Reasonable Price (GARP) style investing.

However, I place very little weight on trying to make growth predictions. Or as Yogi Berra said: “It’s tough to make predictions, especially about the future.”

Without relying on future gazing or prediction, is there a way those with a value mindset can use growth to aid stock selection? Yes, by using the power of trends.

Using screens, the approach I use includes looking for stocks which have:

  • Earnings growth rate over 5 years of 15-35%
  • Price Earnings to Growth ratio (PEG) <1.0

A screen is only ever a starting point for further investigation and qualification. Looking at each of the above criteria in turn:

5 year Earnings growth 15-35%

Peter Lynch, in “One up on Wall Street”, referred to his search for Fast Growers. These were magical stocks where he could score 10x returns or more – the legendary 10 baggers – which would have a transformative effect on any portfolio (particularly as a private investor where I hold only 8-12 stocks at any time).

Lynch said when searching for these he would target those stocks with 20-25% annual earnings growth. Only a handful of these will become 10 baggers and you will not be able to tell which in advance. So you need to buy a few.

By tracking the company story and stock progress, the 10 baggers will emerge; some stocks will falter in their growth rates and fall by the wayside (but may still offer satisfactory returns). A few will continue to grow at healthy clips after you’ve bought them. These can become the 10 baggers.

Lynch described these as high risk, high reward plays, and typically had around 30-40% of his overall portfolio in growth stocks.

He balanced the risk by spreading other assets around Slow Growers (paying dividends), Stalwarts (big, steady growers), Cyclicals and Turnarounds. Running a $multi-billion required such diversification by approach.

Stay focused

I’ve widened the growth bar as I can still find attractive opportunities that could double in 5 years while capturing a growth factor. While writing this post I did a screen which breaks out as follows: Total stocks = 108; 5yr EBITDA Growth: 15-20% = 30; 20-25% = 36; 25-35% = 42

It’s a way of staying focused on your niche (for me this is GARP), while reducing the risk element and not having to look for stocks in each of the above categories. The upper limit is set at 35% as more than this is very difficult to maintain.

I also refer to the 10 year earnings growth nos., to see what the history is like. While it’s nice to see a long history of earnings growth, I don’t require it absolutely as it could eliminate opportunities which have had a shorter but still valid run.

I use Gurufocus for screens and 10 year data, and cross check with 10-K filings and Yahoo! Finance.

Price Earnings to Growth, PEG <1.0

This was most famously used by Lynch and also Jim Slater, famed UK investor and author of “The Zulu Principle.”

The ratio is simply the Price Earnings (PE ratio) divided by the Growth rate. Less than 1 is good, the higher it gets the more you are paying for growth.

Now here’s the challenge: Financial websites often quote historical growth rates and use these to calculate a PEG. I look for those with a PEG < 1.0. However, that’s just the first part of the growth screen. Beyond that how do you know what the forward growth rate is going to be? You don’t.

Discount the growth rate

What can you do? I look at the 5 year historical earnings growth rate and apply a discount factor. Depending on factors around the business, gleaned from reading and research, I usually discount the growth rate by 20-30%.

In any event, I never ascribe a forward earnings growth rate of more than 15%; few businesses grow unhindered into the future.

They might do very well, sometimes better than expected, in which case it comes a nice surprise. But even if a business is doing very well, over time the advantage is usually eroded away through competition, pricing pressure, increasing input costs, trend changes or other factors.

I then apply that growth rate out 5 years to the current revenue, apply a margin percentage which is historically repeatable (whether net margin for net earnings, or operating margin for EBIT), and arrive at a five year earnings projection.

Ride the trend

The important point is that this is not a hard prediction based on how well I guess the business will do going forwards. I make no predictions about future market share, product sales, new products lines, etc. But what I do is look at rolling out the existing trend, where it shows a good pattern of repeatability, at a reduced growth rate.

While this is not foolproof (no system is), it goes a long way towards reducing personal bias, negative or positive, that I might have towards a business or sector. It also stops you from believing any growth story too keenly.

From the 5 year forward earnings, then applying a multiple which you think is realistic (again looking at historical precedent), gives a fair price valuation. From here you derive a current buy price at half the 5 year value. This would enable a CAGR of 15% (i.e. at 15%, prices will double every 5 years).

What about value based earnings ratios, like Price Earnings?

When using a PEG ratio and healthy historical growth rate, I don’t usually include a PE ratio within the screen. The risk is that it becomes too exclusive, throwing out the baby with the bathwater, and not leaving enough candidates to research.

However, you still apply a historically conservative PE ratio as a valuation multiple. Thereby, the value element is added through both the PEG ratio and the PE ratio.

Other metrics

While market cap is more likely to be lower for faster growing stocks, I don’t use this as an exclusion criteria. If everything else is in place, a $10 billion company could still grow faster and offer better returns than a $1 billion one.

Though if anything, I usually set a low end market cap of $500 million, simply because I’ve found buying these from a UK brokerage account can be hampered by trading lot size, liquidity and spread inefficiencies.

To cap it all, I look for healthy balance sheets with debt:equity <0.4, and think about return on equity (ROE) – even though it’s not a primary driver.

What’s your style?

Over the years, investment greats that have particularly influenced my style include Buffett, Lynch and Seth Klarman (Trades, Portfolio). Others that have also aided my learning include Ben Graham, David Dreman (Trades, Portfolio), Joel Greenblatt (Trades, Portfolio) and Nassim Nicholas Taleb. That and a lot of practice.

As you read and develop your investing interests and style, some gurus will have greater influence than others. You’ll also find your specific style develops over time (while still broadly value based, I’ve gone from low PE to GARP style investing).

No one should try to blindly emulate anyone – rather take what makes sense to you, what you can use and what fits with your own temperament and investing personality.

What’s your investment style?

Raman Minhas writes about using value investing, saving and psychology to help you reach financial freedom. If you enjoyed this article, join his free newsletter.

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