In the well-known fable "The Tortoise and the Hare,"the tortoise scores a surprising victory in his footrace against the much faster hare. The moral at the end of the story is, "Slow and steady wins the race."
Being slow, however, was no factor in the tortoise's victory. It was being steady, as in persistent and consistent, that led to the astounding outcome. In this article, we'll draw our inspiration from the approach Aesop's tortoise used to win the race to demonstrate an equity investment strategy that focuses on steady growth companies.
Predicting a Stock's Future Price
Earnings per share (EPS) is what drives the value of a stock. Even though cash flow and free cash flow are more instructive, the market pays attention to and reacts to earnings. The more accurately you can determine the path of a company's future earnings, the more accurately you can determine the price path of that company's stock. Some companies have a history of producing relatively steady, predictable earnings growth. Other companies have a history of producing earnings in a much more erratic fashion. Focusing on the steady growers takes much of the inherent unknown out of the prediction process and leads to a less volatile investment outcome.
Predicting a stock's future price can be a simple function of two variables - its future earnings per share and its future price-to-earnings ratio (P/E ratio). Multiply the projected P/E ratio by the projected EPS and you get your projected price per share.
A stock's P/E ratio will fluctuate constantly depending on current earnings expectations and interest rates. It is very difficult to project what the P/E ratio will be at any given point in the future. A stock's historic average P/E ratio is probably as effective a predictor as any and better than most.
Fast and Steady
A company may have a history of producing relatively steady and predictable earnings, but the anticipated growth in its earnings going forward may be slow. This is a true tortoise stock. Unless it is greatly undervalued at its current price, there is little prospect its stock will appreciate significantly because earnings are growing so slowly.
There are stocks, however, that combine this steady nature with relatively fast expected earnings growth prospects of at least 10% annually. Unless a stock is greatly overvalued at its current price, it will have a chance of appreciating at a rate that is competitive with the historic growth rate of the overall stock market. The return goal of investing in steady growth companies is to equal or exceed the average return of the equity market in a manner that is less volatile than the market.
Volatility Is Not Your Friend
Volatility is not a friend of the average investor. A famous study released in 2003 by DALBAR, a leading financial services marketing research firm, revealed that over the preceding 19 years the unmanaged S&P 500 Index had earned an average of 12.22% annually. Yet, over that same period, the average equity mutual fund investor earned a paltry 2.57% annually. The huge performance differential had little to do with the returns of the average equity mutual fund, which performed just shy of the index itself. It had everything to do with investors being unable to manage their own emotions - moving into funds near market tops and bailing out at market lows.
Volatility whipsaws an investor's emotions. The more you can control volatility, the more likely you are to avoid making investment mistakes caused by your heightened emotional state. Hare stocks, with their erratic earnings growth, are prone to volatility because their earnings are much more difficult to predict with accuracy. As a result, their future share prices and return prospects are harder to predict. Current values can change quickly and dramatically as current earnings results and future earnings prospects gyrate. Steady growth stocks largely avoid all of this drama, and avoiding drama is a great way to prevent emotional mistakes.
Identifying Steady Growth Stocks
How do you find and identify steady growth stocks? Value Line and other publications provide a history of a company's past earnings. You can analyze these earnings to get a sense of how steady the earnings growth has been in the past. Relative scores of earnings predictability and the stability of the stock's share price are also available. By reviewing this data, you get a sense of who your tortoise candidates are.
As stated above, the goal is to identify tortoise-like stocks that have healthy projected earnings growth rates. You can use consensus five-year earnings growth estimates that are freely available from a whole host of sites. Projecting future earnings is not an exact science and analysts make mistakes, but the consensus is probably as accurate as anything you could generate on your own.
You need to start with stocks of companies that not only have a history of the most stable and predictable past earnings growth, but also have five-year average earnings growth rates projected to be a minimum of 10%. Very few of these stocks exist, however. In order to increase your universe of candidates, you need to require higher expected rates of earnings growth as you lower your predictability standards. You will not have to lower these standards very far before you have a sufficient pool of candidates from which to build an adequately diversified portfolio of around 30 stocks.
As you go through the process, you will notice that some industry sectors contain many more steady growth candidates than others. The consumer discretionary, healthcare and industrial sectors are ripe with selections, while technology, telecommunications and utilities provide fewer candidates. The latter industries either rarely have 10% expected earnings growth (utilities) or have overly erratic past earnings (technology). Still, steady growth stocks exist in all sectors and you will need this diversified exposure to mitigate the risk of your overall portfolio.
Determining Return Prospects
Once you have determined an appropriate P/E ratio, you can multiply that ratio by a stock's past 12-month earnings to determine a rational current share price. You can then project future share prices based on the expected growth rate of earnings. In other words, with an assumed constant P/E ratio going forward, the share price will advance at the rate of earnings growth.
The market will have set a current price for the stock that will typically be different from the current value you have assigned. Using a simple "present-value/future-value" calculator, you can easily determine the average annual return prospects of the stock from the current market price to one of your projected future prices - preferably the one that is four to five years out.
Any stock, even a steady growth stock, may be overvalued by the market at any given point in time and thus not suitable as an investment. If the average annual return prospects at the current quotation are less then 10%, you probably want to look elsewhere.
Once invested, you need to monitor the holding to see how future earnings growth prospects change. Growth expectations change far less for steady growth stocks than for the average stock, but they do change.
The Benefits of Patience
Imagine for a moment that you are a spectator at the race between the tortoise and the hare and that you have placed a wager on the tortoise. As the gun sounds, the hare quickly sprints into the distance, while the tortoise is just beginning its first lumbering step. The tortoise - like steady growth stocks - is competitive in the long run, but there are times when the hare will run far, far ahead, and may even hold that lead for a long time. It is at these times you must remain patient. Eventually, the hare will run out of steam - or even begin running back toward the starting line. In recent memory, we have experienced two major hare reversals - first with technology stocks in the early 2000s and then with financial stocks in 2008. In the future, we will certainly experience other such occurrences. If you focus on the steady growth stocks, you can win the long-term race and avoid much of the volatility and gut-wrenching emotion that sabotage the rabbit riders.
The Bottom Line
Successful equity investing is a marathon activity, not a sprint. It requires patience, discipline, a rational valuation process and an ability to manage emotion. Investing in steady growth stocks positions you perfectly to succeed in the long run. Don't chase the hares. Bet on the tortoises and win the race.
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