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Keep the profits coming
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December 28, 2001: 6:27 p.m. ET
Identifying sustainable growth is the key to long-term investing.
By Michael Sivy
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NEW YORK (CNN/Money) - I'll be writing chiefly for MONEY Magazine in 2002, so this online column will cease at the end of the year. I'm devoting these last few columns to general investing questions. So far, I've discussed what you can do to protect yourself against a possible resurgence of inflation and how a sophisticated understanding of diversification can improve your strategic choices. Today, I'll look at the issue of sustainable growth. And on Monday, I'll size up the economic outlook for the coming decade.
The key to long-term investing is identifying stocks that can turn in fairly consistent earnings increases for years in a row. Analysts call this sustainable growth, as opposed to the sudden bursts of profit that companies report for a few years but can't maintain. It's only common sense that long-term investors would look for sustainable growth, but the fact is that most stock buyers undervalue it and are willing to pay up instead for strong earnings momentum.
The attraction of earnings momentum is easy enough to understand. If a company's earnings are rising and the size of the gain gets bigger each year, the stock's price/earnings ratio will probably move up. As a result, the share price will rocket, propelled by both bigger earnings and a higher P/E. Such stocks can quickly turn in enormous gains, which is what attracts short-term investors. But like tech stocks in recent months, they get killed in a downturn. Not only do their earnings drop precipitously, but their P/Es also collapse.
The beauty of sustainable growth investing is that it enables you to ignore short-term fluctuations in P/E ratios. And that means you can ride out bear markets without having to worry.
Do the math
Let's look at the numbers. Imagine a stock with 14 percent compound growth, little year-to-year variation in the growth rate and a price that's 28 times earnings. In a bad bear market, the share price might drop 40 percent to trade at a 17 P/E. But as long as the earnings come through, they'll boost the price enough to offset the lower P/E in less than four years. Moreover, the stock will probably recover its 28 P/E by the next market peak.
So as long as your time frame is long enough, your compound total return will at least equal the company's 14 percent earnings growth, plus whatever dividends are paid. At a minimum, you'd more than quadruple your money over 11 years.
In addition, companies with growth rates between 12 and 20 percent are more likely to maintain their gains than stocks with growth of more than 20 percent a year. Nonetheless, stocks with the fastest growth generally win premium P/Es, while sustainable-growth stocks are chronically underpriced. That's the case right now, with sustainable-growth stocks at their lowest valuations since 1985.
To take advantage of these buying opportunities, what should you look for? For starters, make sure the company is in an industry that is growing faster than the overall economy. Health-care has a high core growth rate -- so does computer-related technology. So does telecommunications, even though it is depressed at the moment and may need another couple of years to come back. Aerospace, which is also depressed, qualifies. Top-quality financial-services companies make the grade. And entertainment has well-above-average growth prospects.
Companies in highly profitable niches in industries with average growth rates are trickier. Specialty chemicals are a classic example. They may offer above-average growth rates and sell at modest P/Es. But you have to be careful that the companies are not in danger of outgrowing their niche. If they get so big that they have to diversify into stagnant parts of their industry, their growth rates will be diluted.
The best business mix, as I discussed on Wednesday, is a diverse assortment of product lines, even if they are all in the same sector. Johnson & Johnson, for instance, is lower risk than Amgen, which has only two or three big products. And AOL Time Warner, with a variety of entertainment-related operations, has held up better during the bear market than Disney has.
If a company is in a rapidly growing industry and has multiple business lines, all of which are solid, does that ensure that its growth is sustainable? Not entirely. It's also important to check that the company can finance its growth. Consider a restaurant chain, for instance, that relied on opening new stores for much of its growth. If the outlets need several years to reach breakeven, the company may have to go deeper and deeper into debt to finance new openings. Eventually, the debt burden will become crushing and growth will have to slow.
Ultimately, it's the company's track record that demonstrates whether earnings growth is sustainable. If debt has remained stable or declined as a percentage of long-term capital, you probably don't have to worry about financing. If earnings have risen at a compound rate of more than 12 percent annually for longer than six years, the company meets the growth threshold. If there have been few declines in earnings -- and the ones that have occurred are shallow -- the stock meets the test for stability.
Typically, companies that have such growth characteristics also pay dividends, and raise their the payout consistently over long stretches of time. J&J, for instance, has increased its dividends for 39 consecutive years. Of course, no track record -- no matter how good -- guarantees the future. Only steady sales growth can support rising earnings for more than a few years. So it's crucial that you believe the company is focused on businesses that have strong prospects.
When you find stocks that meet all those criteria, start following them and be prepared to add them to your portfolio when their prices seem reasonable. Don't worry about what the next quarter looks like or how the stock has performed over the past six months. Don't wait for a ridiculously cheap share price or try to catch the exact bottom. If you've sized up the stock correctly and earnings do come through as expected, the long-term profit potential is enormous. And it's more important to be sure you're on board the train than to jump on it a minute before it leaves the station.
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