Beat it

"The whole thing is that ke bhaiya sabse bada rupaiya", sang Mehmood in the cult classic, 'Sabse Bada Rupaiya'. But, the markets would beg to differ. When it comes to wealth creation, there is no rupaiya without bada growth. Perhaps you are an investor with an eye for value, always on the hunt for companies that are momentarily undervalued due to short-term difficulties. You might pour over financial statements looking for firms with strong balance sheets and robust business models. But without growth, all investment philosophies are rendered mute. So, the June 2024 edition of 'Wealth Insight' revisits the fundamental importance of growth stocks. These are companies that have shown exceptional increases in their revenue and profits. But remember, investing in the equity market always involves risks. Therefore, this issue not only celebrates the advantages of investing in growth stocks but also candidly discusses its potential pitfalls. Additionally, we're introducing a framework to help you independently find reasonably priced growth stocks. Plus, as a bonus at the end of this cover story, we spotlight nine promising growth stocks for you to explore. Let's dive into the world of growth stocks and discover your next big opportunity. Chasing growth: We explore the rewards of investing in growth stocks Investing in stocks is simple. You buy low and you sell high. But the critical question remains - what propels a stock's price upward? Now, this has ignited fierce debates among investors. We won't pick any sides either. But, one truth seems absolute: A stock needs to woo investors to go places in terms of value. So, how does a company make investors swipe right? It could hog the headlines, sparking a fling of widespread interest. It may benefit from a regulatory or geopolitical windfall favouring its sector. But, when the novelty wears off, only one thing keeps the love alive - growth. If a company consistently grows its revenue and earnings, it looks like a better and better catch. The longer it can strut its stuff with impressive growth rates, the more serious investors get about committing, boosting the stock's appeal and its price. Dixon Technologies is a case in point. The electronic manufacturer grew its revenue by 43 per cent and profit after tax 39 per cent annually in the last five years (as of TTM December 2023). And Mr Market was surely impressed. In the same period, its share price skyrocketed 16 times! Dixon's meteoric rise is no solitary tale, either. Historically, the market has favoured stocks with high growth rates. Notably, companies with a five-year annual revenue and profit after tax growth of higher than 15 per cent have outperformed those with lower growth rates. So, here's where we stand: Growth rates are the primary drivers of a stock's price in the long term. Investing in stocks with higher growth rates can fetch you high returns. But here's the head-scratcher: why don't all investors just chase after growth stocks? The answer is that blindly chasing growth has its costs. The cost that growth exacts Are you familiar with the Norse myth of Siegfried? A great warrior, Siegfried bathed in the blood of a dragon, Fafnir, and became invulnerable wherever the blood touched his skin. However, a single leaf stuck to his back during this bath, leaving just that spot unprotected. Eventually, Siegfried was killed when a treacherous friend, Hagen, struck him in this unprotected spot with a spear. The market, much like Hagen, can be equally treacherous. Blindly chasing growth might leave your portfolio as exposed as Siegfried's leaf-covered back. Here's why. Nothing lasts forever: You cannot accelerate a car indefinitely. Growth stocks are no different. A company may start out with ample room to expand and zoom ahead at breakneck speeds, but eventually, every nook and cranny gets explored, every market saturated. And remember, the taller you are, the harder you fall. The markets are quick to downgrade stocks once the growth rates slow down. The tale of Dabur exemplifies that a slowdown is inevitable. Between FY04 and FY09, the fast-moving consumer goods major experienced exponential growth in revenue and earnings. This led to its share price skyrocketing, as shown in the graph 'The tale of Dabur'. In fact, the rising consumption of the Indian middle class led to a bull run in the FMCG sector. But eventually, consumption became saturated, while growth rates and returns slowed down. The last mile is the toughest: If you've ever run a marathon, you know those final metres feel like running through molasses. Similarly, as a business matures, the growth spurt needed to keep up the pace can require herculean efforts. For example, Ultratech Cement managed to double its capacity in six years (FY14-19), which is no small feat. Yet, aiming for the next milestone feels like trying to summit the Everest without oxygen. Also, a larger business is difficult to manage. Management might have shown excellence on a smaller scale. But there's no guarantee that it can replicate its success at a larger scale. The nosedive of Network18 Investments shows how quickly grandioseness can turn from a boon to a bane. In the early 2000s, a partnership with CNBC helped Network18 launch several new channels. But, over time, managing such a wide array of channels became a burden, and its finances started declining. Consequently, the stock fell 86 per cent between 2007 to 2012. The curse of fame: Say you spot a company with exponential growth in the past few years. Its balance sheet is robust, and there's considerable growth opportunities. Sounds like the perfect investment. But would you buy the stock at a P/E ratio of 100 times? High valuations often turn out to be the Achilles' heel of growth stocks, turning a seemingly perfect investment into a potential pitfall. Our graph 'Valuations: The Achilles Heel' shows how even the most promising stocks can leave investors with more tears than profits when the valuations are sky-high. In fact, stocks with annual earnings growth of as high as 20 per cent have left investors with single-digit returns due to P/E corrections. If you consider the opportunity cost, these investments are actually loss-making. So, to conclude, here's what you should keep in mind when dabbling in growth investing: Past growth is not a guarantee for future returns. If a company is near the end of its growth cycle, it may not be able to replicate its past success. Even if you spot growth stocks with promising future outlooks, high valuations can lead to losses. But don't lose hope yet. Every investment strategy has its kryptonite. Yet, the wiser investor skips over the pitfalls and finds success. We have developed a checklist for you that can help you minimise the above risks. Foolproofing against pitfalls: Parameters to keep in mind when looking for growth stocks We have highlighted how the quest for growth stocks is riddled with pitfalls. But the rewards they offer are too valuable to ignore. To help you navigate the risks smartly, we have devised a checklist to ensure that your growth stock picks have the following traits: Reasonable valuations: You must not overlook the value component of the growth equation. Pick companies that not only boast high growth but also trade at a reasonable valuation. Since P/E multiples alone are insufficient, combine them with other valuation metrics, such as the PEG (price/earnings to growth) ratio, to judge the attractiveness of the investment. Sustainable growth: Ensure that the company can sustain its growth. Is it only riding short-term tailwinds? Are the factors driving its growth outside its control? If so, it's highly likely such growth may not last long. Further, do note if the respective industry is still fertile enough with growth opportunities or not. High capital efficiency: Besides growth, a consistent and healthy return on capital is just as important. If a company's return on capital is lower than its cost of capital, the higher it grows, the more its value erodes. Hence, pick a company with above average growth and a good return on capital over one with exceptional growth but poor returns on capital. These factors alone do not make growth investing fail-safe, but they will help you minimise the margin of error. But note that the checklist is just the prequel. We have developed a robust framework for a more definitive approach to growth investing. Our methodology: Finding a balance between high growth a

This article was originally published on June 01, 2024.