This report was written by John Abernethy and published on the ASX website on 5th May
As the market focuses more on dividend yield, some so-called ‘growth’ stocks offer long-term potential – but consider valuations first.
Today’s so-called growth stocks have a whiff of glamour about them. There is something exciting about fast-growing companies and the prospect of continued high returns.
The Australian market has seen some growth stocks emerge, such as internet darlings Seek, REA Group and the fast-food chain Domino’s Pizza Enterprises. Each has been pushed higher with dizzy price-earnings (PE) ratios, which means continued high growth is expected.
There is no doubt that growth is good: a company should be expanding its business, which along with dividends will ensure a healthy return to owners. But the quest for growth and growth stocks should not mean investors forget the fundamentals.
A growth company’s business model should deliver sustainable growth, and like any investment you should pay a reasonable price for a stock to ensure you receive an adequate return.
My message is clear: growth stocks can be good but don’t get caught paying too much for them. Our favoured growth stock picks below may surprise you.
(Editor’s note: Do not read the following ideas as stock recommendations. Do further research of your own or talk to a financial adviser before acting on themes in this article).

Different types of growth stocks

On the face of it, a growth stock should be considered one that can sustainably grow its earnings or revenue at a multiple of GDP (economic) growth. An example is Ramsey Healthcare.
Growth stocks are often contrasted with so-called defensive and income stocks – companies that are not growing as quickly but are paying high dividends. But if you drill down further, you will find there are actually a number of different types of growth stocks.

  1. Growth stocks that are expanding through internally generated growth
    They are not expanding through acquisitions. You might think of Woolworths or the major banks as examples. Major infrastructure assets leveraged to GDP (such as airports) are also relevant. They are leveraged to a growing economy and consumption or credit growth.
  2. Some growth stocks are tied to a theme
    An example is healthcare stocks, such as Ramsay Healthcare, which are benefiting from an ageing population and increased spending on healthcare. Other sectors that fit this category include education, which is boosted by society’s drive for better education and skills. Tourism would also fit this group.
  3. Some companies and industries are growing rapidly for cyclical reasons
    The most recent example was resource stocks such as miners. For some time they grew quickly off the back of the cyclical rise in commodity prices and growth in China.
  4. There are IT and technology growth stocks
    These are generating huge growth from human ingenuity and technological developments such as mobile devices and entertainment. Internationally, this group includes big companies such as Apple, Google and Facebook. My question is: are they sustainable growth companies or fads?

Sustainable growth

The problem with many fast-growing companies is their lack of sustainability over a long period. They have a few years of rapid growth, and then naturally slow down as lower economies of scale apply or new entrants come into their markets.
There is a temptation for the market to assume fast-growing companies can sustain growth in perpetuity. Investors often make assessments based on today’s news rather than looking, say, two years into the future. This is why the market often overpays for growth and is disappointed when lofty expectations are not met.
Investing is a long-term game, so the growth stocks you invest in should have clear sustainable characteristics.
If the entry price is right, I would always prefer to invest in a stock that is growing steadily at 6 per cent per annum over a decade, rather than a company that has a potentially short three-year growth spurt of double digits with no clear proof of sustainability.
Companies with sustainable growth tend to have reasonably good market share, are self-funded and have proved through the test of time that they are growth companies.
Take Telstra as an example. It has steadily grown at 5 to 6 per cent a year for the past five years despite upheaval in telecommunications markets. That growth is three times population growth and twice economic growth.
If Telstra sustains that growth for 10 years, its total returns, including dividends, will be around 10 to 12 per cent per annum – an extremely attractive return for investors.
So when it comes to growth, there is an argument to consider the tortoise over the hare growth stocks.

The right price

The other key to buying growth stocks is price. It is easy to get lured into the excitement and potential of growth and pay too much. It is foolish to buy growth at any price. The price paid determines the return, so you want to pay a fair price.
Some say that if you take a 30-year view on the major banks, such as Commonwealth Bank and National Australia Bank, you will make money. But how much you pay for the banks radically alters how much you will earn from your investment. Your rate of return could be 10 per cent if you bought after the Global Financial Crisis when bank stocks fell, or 5 per cent if you bought before the GFC.
Before buying a stock we always look at the valuation. We test the valuation by calculating the sustainable return on equity and ensuring required returns are appropriate. Growth stocks are no different from any other stock.

Looking for growth now?

Along with price and sustainability, the other factor to consider is the market environment. Should you be looking to buy growth now?
The good news is that there are significant tailwinds in the market. Low interest rates are helping the sharemarket. But it is also a time to be sensible. Rates are very low because the global economic environment is still unstable.
We are also very near the end of interest rate support; interest rates cannot go much lower, and it’s more a question of how long they can stay low.
Additionally, low interest rates make valuing stocks difficult. The very low-rate environment means investors are presented with the temptation to pay high prices for companies with sustainable growth.

Growth stocks we favour

The key in this environment is not to overpay for growth, and there are a number of growth sectors I believe are sustainable:

  • Non-discretionary retailers
  • Commercial banks
  • Education companies
  • Tourism operators
  • Healthcare groups

I particularly like non-discretionary retailers, such as Woolworths and Wesfarmers. They may not look as attractive as companies growing 10 to 15 per cent, and their returns are lower in the short term. But their growth is sustainable and dividend yields excellent to allow compounding of returns to occur.

Don’t forget fundamentals

As I’ve mentioned, growth is an important factor in generating returns from equities. But look for companies that have sustainable growth. Look back at their track record, their products and services, and their market share. Then wait until you can pay a reasonable price for them.