Growth investing is broadly classified as the quest to invest in businesses that offer strong, consistent earnings growth. Valuations usually tend to take a back seat in this investing philosophy. The belief is if growth remains strong, valuations will not be a hurdle to generating returns. To explain this better let us consider the example of a leading Consumer company, Nestle India Ltd. which has exhibited consistent growth over years. Its ten year price chart reflects as under:

Source: yahoo finance

Over a ten year period (Jan 2013 to Dec 2022), Nestle’s stock price has more than quadrupled from Rs 4900 to over Rs 20,000 for healthy CAGR returns of 15.1% (ex-dividends). Over this period it has massively outperformed Sensex as well. In the same period the company’s EPS has grown from Rs110 to Rs222 at a CAGR of 7.2%. This growth happened at high Returns on Capital Employed (ROCEs) ~ 10 year average ROCE of 56%. The stock traded at 45x PER at the start of this period and today it trades at 90x PER. Clearly 45x PER was not cheap, however as the above data suggests the stock’s Price to Earnings multiple (PER) further expanded over this period as growth continued to surprise market expectations. This multiple expansion could be explained by valuations of the frontline index (BSE Sensex) expanding to 23.9x from 17.1x and balance by earnings surprise. 

However, if we look at the stock performance between March 2015 to March 2016; the stock fell approx. 31% significantly higher than Sensex’s 10% fall in the same period. This significant underperformance was primarily led by sharp decline in earnings; Nestle’s EPS declined from Rs122 to Rs58 in this period.In the past, similar instances of severe underperformance (vs Sensex) have been seen in other high quality, richly valued, growth companies like HUL (Jan 2001-Mar 2010; Apr 2020- Dec 2022), Hero Moto (Nov 2015 to Dec 2022), Sun Pharma (Jul 2014 to Dec 2022), Symphony (Nov 2014 to Dec 2022), etc. What is common in these phases for the referred companies, is growth slowed down and ROCEs compressed. 

Past trends in growth investing, offer the following key lessons for investors:

  1. Great growth companies trade at premium valuations as they generate growth at high ROCEs
  2. This premium valuation sustains as long as growth sustains and incremental investments in business generate high ROCEs
  3. As growth slows down and incremental investments generate lower ROCEs, PER multiples tend to contract and stock price underperforms

In order to avoid entering growth businesses at inappropriate valuations, it becomes critical to understand when the Earnings tide is turning on growth. Growth tends to mean-revert, hence there will always be phases when a growth stock performance will disappoint.

Key guiding principle to successful growth investing

At Kotak Asset Management, we believe that the key to successful growth investing is to estimate the level of expected earnings (EPS) growth embedded in the current stock price and then to assess the likelihood of a revision in EPS expectations. A stock’s price is the clearest and most reliable signal of the markets expectations about a company’s future EPS performance. If expected EPS growth embedded in the stock price are too lofty then it is reasonable to avoid the stock. There are always chances of a company missing market’s lofty earnings expectations, in which case the stock could fall/underperform. On the other hand, conservative EPS expectations could set up a stock for future success. Investors who are able to correctly judge market’s expectations and anticipate future EPS revisions, enhance own odds of achieving superior investment results. Hence valuations matter. 

For example, a leading air cooler company’s last ten years’ net profits grew from Rs60 Cr in FY13 to Rs193 Cr in FY18 (i.e. 26% CAGR) during which period the stock price rallied approx. 10x. Come 2018 the stock hit a price of Rs2,000 trading at PER of 72x. At this price the markets started to build in lofty earnings expectations of 1) 16% revenue CAGR growth over next 10 years, 2) EBITDA Margin expansion to 30% (vs 28% in FY18); and 3) significantly high terminal growth rate of 8%…..These expectations seemed unrealistic on a reasonably high growth base of the previous 10years. Between FY18-FY23E, the company disappointed on embedded earnings growth expectations and the stock price significantly underperformed the index ~ down 55% vs index being up 60%. The business continued to be top quality but investors’ expectations embedded into stock prices were running much ahead of reality.

If investors are disciplined and consistently position themselves away from such lofty expectations, chances are they will avoid disappointments. This is easier said than done, since inherent biases in investor psychology push them toward pockets of exuberance. Tendency of Social Proof or Herd mentality pushes an investor to seek pockets where others are investing. However by virtue of others’ buying, these pockets may be over-valued and are hence best avoided. Similarly, loss avoidance tendency makes an investor shun investing pockets which have seen recent disappointments and where investors currently have least interest. Valuations in these pockets could turn out to be favourable, given general investor apathy toward these pockets. 

In summary, to avoid missteps in growth investing, investors need to follow two key steps:

  1. Keep a close watch on growth and identify when the tide on growth is turning adverse
  2. Control own biases to avoid pockets of exuberance

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