Growth-Stock Investing: Lessons from the Pros

Growth-Stock Investing: Lessons from the Pros

Iva Hruzikova / The Fiscal Times

To many investors, online retailing behemoth Amazon (NASDAQ: AMZN) is a riddle contained in a mystery, wrapped inside an enigma (with apologies to Mr. Churchill).

The company’s stock is trading at more than 1,400 times its earnings for the last 12 months, while the S&P 500 average tends to hover at perhaps 1.2 percent of that level. That’s not the highest Amazon’s multiple has been; a year ago, you’d have to have been willing to fork over more than 2,700 times Amazon's annual earnings to buy the stock.

That’s a hefty premium by any standards, even though since then the stock has gone from about $250 to $400. Meanwhile, its profit margins are so razor thin as to be almost invisible – and in some cases, as in three of the last five quarters, have been negative. On a year-over-year basis, quarterly profits have shrunk over the last three years.

You can grumble that Jeff Bezos’s decision to starve Amazon’s bottom line in order to finance its ongoing expansion mean that it’s not shareholder friendly, but even before the publicity around those planned delivery drones, enough investors were willing to buy into the company’s future promise to drive its price up 55 percent in 2013.

Related: The Real Amazon Price War – Where Should Its Stock Be?

Still, even those who are bullish about the company’s business model and believe that Bezos will find ways to boost profits are wary these days. They applaud the company’s big investments in web services, its low overhead and its ambitious plans. But, as a team of analysts from Wedbush wrote in a note recently published in Barron's, “Amazon is unlikely to provide investors with a strategy road map.” Moreover, they noted, “it could be a long time before (earnings per share) grows sufficiently to justify its share price.”

Here’s the conundrum confronting investors today: For all their premium valuations, growth stocks are basking in the sun once more. About the same time that interest rates reminded us that they could go up as well as down, the allure of stable, dividend-yielding stocks began to fade and investors began to seek out growth – and show their willingness to pay up to obtain it. As earnings season gets underway, investors will be paying particular attention to companies that manage to buck the trend of slowing profits.

Not everyone believes nose-bleed valuations are a bad thing, however. Indeed, small- and micro-cap growth stock managers – whose mutual funds turned in astonishing performances in what was already a great year for stocks – view paying a premium as being a form of table stakes: It’s what you have to do to get in on the ground floor of a high-growth company like Amazon. They’re seeking out the companies that are going to be disruptive and benefit from that upheaval.

Whether it’s in an existing business (retailing dates back to the dawn of time, and even online retailing is now mainstream) or something new – a biotech company doing research on the frontlines of genomics, perhaps, or a tech startup that has devised new approaches to Internet security – these disrupters completely change the way we think about the business opportunities.

Consider eBay (NASDAQ: EBAY): Before the Internet made it possible, its $14 billion business (measured in revenues) didn’t really exist. Yes, there were auction houses, but eBay transformed that concept and grew it to massive scale. (Sotheby’s (NYSE: BID), by comparison, had revenue of $514 million through the first nine months of 2013.)

Yet even fund managers who are scouring the landscape for next-generation “transformative” businesses hesitate about buying growth at any price. They know that they need to blend their focus on the long-term prospects of a company with a degree of discipline.

Here’s an example: One of the hottest investment trends of 2013 was 3-D printing; machines can be used to make everything from guns to chocolate. And one of the year’s hottest IPOs was that of Germany’s Voxeljet AG (NASDAQ: VJET). Tom O’Halloran of the Lord Abbett Micro Cap Growth fund (LMIYX) snapped up Voxeljet stock at its $13 IPO price and sold for $55 a share only a few weeks later.

“We got a healthy allocation, because investors were worried at owning such a small capitalization stock,” he explained to me recently. Despite his penchant for growth and his conviction that the company and its industry will be game-changers, the sudden surge in Voxeljet’s valuation made it too rich for his blood.

So how do the most successful pros navigate the growth-stock conundrum? What last year’s top-performing managers had in common was their willingness to always look past the “noise” of today’s markets. Instead of comparing to a company’s share price to its recent earnings reports or even what it might generate in profits in the coming year, they compare it to what they believe the business could look like in five or even 10 years’ time.

Nor is profitability their only criterion. Some growth stock investors actively hunt for companies run the same way that Bezos runs Amazon. “I don’t mind if a CEO behaves as if he’s still running a private company,” says a veteran growth stock manager. “But what I need to see is evidence that a company has a great idea, some kind of first mover advantage, and a market that is developing very rapidly and that has tremendous advantage. Understanding the long-term end-game potential is more important” than the price/earnings ratio for these companies, he added.

Of course, if you’re going to chase after growth and end up owning a portfolio of stocks whose valuations are in nosebleed territory, you’ll need to do a fabulous job of risk management. (Some of those I’ve heard quoting Warren Buffett most frequently tend to be growth managers, oddly enough.)

That could mean setting aside only a small part of your overall portfolio for these stocks, using options to hedge your downside risk, or re-revaluating these stocks every time they move more than 5 percent or 10 percent, to make sure your thesis is still intact. Because the more turbo-charged a growth stock becomes, the more volatile it becomes.

Just look at Voxeljet, the stock that O’Halloran bought at $13 and sold at $55. It went on to climb as high as $68.37 a share – but only stayed there for a day. O’Halloran isn’t mourning the loss of an extra $13 a share, and nor should anyone be: The stock now changes hands for $44 a share.

The lesson: Just as there’s a “value trap” (the risk of being stuck in a value-priced stock that keeps getting cheaper and cheaper), so you’ll need to remember that there’s an equivalent “growth trap,” even if you don’t know it by that name. It’s the risk that you’ll end up so hypnotized by a CEO’s vision of an unlimited horizon and future profits that you fail to stop and think about the risks. If growth stocks keep zooming higher, tread carefully.

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