Philip Fisher and Thomas Rowe Price Jr. are the two individuals most associated with growth stock investing as a valid and important investment strategy. In extreme cases, growth stocks have the potential to go up 1000% or more from inception.
Occasionally, you’ll find a growth stock in the bargain-basement bin. But, usually, it’s up to you to make the assessment that a growth stock will keep growing, and that paying a somewhat high price today is a good gamble for a stock that is headed higher.
A growth stock is like a first-round draft pick: A lot is expected and it is in great demand, so it usually sells at a high price.
One reason is that a stock can split. You might own 100 shares of a stock trading at $50 a share, for a total of $5000. After a 2-for-1 stock split, you would now own 200 shares of the stock at $25 a share, but the aggregate value would remain the same: $5000.
Relying on price alone might not be a meaningful way to differentiate between growth and value stocks. Thus, analysts look at other measures of valuation. The two most common are the price-to-earnings ratio (P/E) and the price-to-book ratio. The P/E ratio is the price of a share divided by its annual earnings per share. If the P/E of the market is at 15, any stock with a P/E of less than 15 would be considered a value stock, while a stock with a P/E higher than 15 would be considered a growth stock.
The price-to-book ratio is the price per share of the stock divided by the book value—that is, the accounting value or net worth figure on the balance sheet—per share. A high price-to-book ratio suggests a growth stock: It’s valued in part on its future potential. A low price-to-book ratio indicates a value stock: It might be undervalued relative to its intrinsic worth.
Another way to differentiate growth from value stocks is the average valuation level of the market. Anything above the current market average is considered to be a growth stock, while anything below average is considered a value stock.
Philip Fisher was born in San Francisco September 8, 1907. He attended Stanford University and earned a bachelor’s degree in economics. In 1931, he set up his own investment advisory firm, Fisher & Company, retiring in 1999 at the age of 91. For many years, Fisher taught an investments course at Stanford, and his location in the San Francisco and Silicon Valley area positioned him to become an early investor in several venture capital and private equity investments.
Philip Fisher is probably best known for his bestselling book, Common Stocks and Uncommon Profits, in which he lays out his investment philosophy.
As a growth investor, Fisher looked for companies with the potential to significantly grow sales for several years into the future. The quality of a firm’s sales force was one of the factors that Fisher assessed. A firm that grows sales at a faster rate than the industry is one sign of a good quality sales organization.
Fisher was also one of the first investors to conduct rigorous fundamental analysis, which goes beyond looking at a company’s financials to include talking to management, competitors, suppliers, former employees, and others. Fisher looked at the integrity of a target company’s management. Signs of quality management included the following factors:
- Management talks freely to investors about its affairs when things are going well and when they’re not.
- The firm is able to keep growing when a product has run its course. Can they come up with a new and improved version? Or pivot to selling a somewhat related product?
- The company’s research and development function, or R&D is robust. Does a significant part of a company’s sales come from new products?
- Profit margins differ dramatically by industry. For example, supermarkets might have profit margins in the low single digits, while software or pharmaceutical firms often have profit margins greater than 20%. Growth stocks typically have above-average profit margins.
Fisher would often ask a company’s management what it was doing to maintain or improve its profit margins relative to its competitors, and he liked companies that had a focus on profits for the long term.
Fisher advocated owning a relatively small number of investments in a portfolio—roughly 30. He felt that owning too many stocks made it impossible to watch all the eggs in all the different baskets. He felt that buying a company without a detailed understanding of the business could be riskier than limited diversification.
Fisher also believed that when finding attractive investments is hard, the market as a whole might be overvalued; you should consider taking some money off the table.
Thomas Rowe Price Jr. was born in born in Glyndon, MD, March 16, 1898. He earned a bachelor’s degree in chemistry from Swarthmore.
After a brief stint as a chemist at DuPont, Price realized that his passion was in the financial markets, and he joined the Baltimore brokerage firm of Mackubin Goodrich, today known as Legg Mason. He worked his way up to become the firm’s Chief Investment Officer, but he wanted to develop his ideas about growth stocks.
After a disagreement with the other executives at the firm, he left in 1937 to set up T. Rowe Price Associates. He charged a fee for his investment services, in contrast to the commission approach that was widespread at the time.
Price produced tremendous long-term returns. If you invested $1000 in his recommended stocks in 1934—with dividends reinvested—it would have grown to $271,201 by the end of 1972 during which time $1000 invested in the market as a whole grew to only about $66,000.
Price is probably best known for his life-cycle approach to investing. He felt that the risks of owning a stock increase when the industry it competes in matures. He wanted to buy stocks when earnings were increasing or accelerating. The industry life cycle typically has 4 stages.
- A period of rapid and increasing sales growth. For example, think about the early stages of the Internet, when many startups occurred and the aggregate industry experienced exponential growth.
- A period of stable growth.Consolidation tends to occur during this phase. Smartphones are one example. Even after cell phones had been around a while, the ability to turn a phone into a mini-computer with millions of apps resulted in stable growth with a limited number of firms capturing the lion’s share of the profits.
- Slowing growth or maturity. Coca-Cola’s stock might be an example. Today, it might be too big and its market too saturated to consistently grow at double-digit rates.
- Minimal or negative growth. The industry revenues and earnings are in relative decline. The railroads were an example of this factor after being eclipsed by the automobile, but they found a second life in transporting increased commodities, rather than people.
Price’s preferred hunting ground was the stable growth phase since it is more predictable and less volatile than the startup phase.
Within the growth-stock universe, Price differentiated between two types of growth. The first is cyclical, where the magnitude of the industry’s growth is tied strongly to the economy. For example, during the 1950s auto sales grew sharply. The other type is stable growth. In this case, sales are not highly dependent on the specific phase of the economic cycle. For example, health care stocks can grow strongly during a recession.
Price also looked at a range of criteria:
- Superior research and development activities likely to spur future growth. 3M—a stock Price held for 33 years—is one company known for its R&D and innovation.
- Avoidance of cutthroat competition. Firms that engage in teamwork are more likely to be stable and around for the long term.
- Relative immunity from government regulation. This criterion knocks out several industries, including utilities, financial services, and energy.
- Low total labor costs but fair employee compensation. Costco made a reputation for generating great growth in its stock price while paying above-average wages to its employees relative to other firms in the industry.
Besides high growth in sales and earnings per share, Price also wanted stocks with at least a 10% return on invested capital. Return on invested capital can be calculated a few ways, but one popular approach divides net income by capital, basically the value on its balance sheet of its debt and equity.
Many industries are defined by a sort of Darwinian process of elimination for achieving high profits. Price recognized this dynamic and suggested finding the most promising company or companies in a growth industry. He also provided some insight on how to determine when a firm was losing its edge.
Companies lose patents and new inventions may make old inventions obsolete. For example, Pfizer’s stock price struggled for years after its best-selling cholesterol drug, Lipitor, went off patent.
The legislative or legal environment can get worse for a firm, affecting its ability to grow. For example, defense firms are largely dependent on the federal budget.
The costs of labor and raw materials also affect a firm’s profitability significantly. For example, the price of jet fuel is one of the largest costs to running an airline.