GREAT BUSINESSES COMPOUND THEIR EARNINGS AT HIGH RATES
The characteristics which growth stocks enjoy were studied by security analyst Thomas Phelps in a book published in 1972 entitled 100 to 1 in the Stock Market. $10,000 compounding at 26% for 20 years turns into $1,000,000.
How high the price of a stock rises over time first depends on the quality of its earnings and on how long those earnings can be reinvested at high rates of return. Therefore, a business generating consistent high ROE and growth in revenue and book value compounds its re-invested earnings at a rate of return at least equal to its ROE, assuming no dividend payments.
Furthermore, price does not solely depend on earning power. Price also depends on the multiple people are willing to pay for the earnings at any given time. For example, while earnings may double over time, price could rise sixfold. This is where the psychology of speculative earnings comes into play. Hence the importance of buying the earning power at a relatively low multiple to leave room for the multiple to expand on top of the earnings increases. In a traditional value approach, the relatively low multiple is called “margin of safety”. For growth investing, I like to think in terms “margin of expansion”, which also allows for building or entering a position even when the price has gone up.
In the same manner, with respect to the rate of return, it should be high enough, but not too high so to leave room for further expansion. A consistent ROE above 30 for the past ten years is impressive but may be hard to improve or sustain. Such businesses may become return of capital vehicles as they mature and are no longer able to grow within their franchise. See for example Coca-Cola (KO).
In sum, a business, preferably small to mid-cap, with quality earning power that is growing its book value while consistently generating a respectable ROE bought at a relatively low multiple could yield extraordinary results over time. A business exhibiting high returns on book value and selling at low Price-to-Book ratio suggests that its stocks may be available at a discount.
Checklist
- Revenue growth
- Book value growth through sales growth and retained earnings
- Consistent high ROE (say above 20, no extreme) with minimal debt and ideally no dividend payment
- Available at a decent multiple with room to expand (on top of earnings growth)
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