SOURCE: Disciplined Growth Investors

Disciplined Growth Investors

June 04, 2013 05:00 ET

Disciplined Growth Investors: Volatility Favors Growth Stocks

Benjamin Graham and the Power of Growth Stocks, Part 7 in a Series

MINNEAPOLIS, MN--(Marketwired - Jun 4, 2013) -

"The stock market is a no-called strike game. You don't have to swing at everything -- you can wait for your pitch. The problem when you're a money manager is that your fans keep yelling, 'Swing, you bum!'"
-- Warren Buffett

For those investors who are comfortable relying on market volatility to make their buying and selling decisions at the most opportune times, growth stocks can provide a significantly bigger pay-off than value stocks, according to author Frederick Martin of Disciplined Growth Advisors.

Martin, the author of "Benjamin Graham and the Power of Growth Stocks" (McGraw-Hill), says the reason growth stocks tend to be more volatile than value stocks (which Martin defines as the stock of a company with little or no earnings growth) is based on simple mathematics.

"In our stock investment strategy, growth stock purchase decisions are based on an estimate of seven years in the future," writes Martin. "Value stock decisions are based on today's value. For a value stock the valuation is much less dependent upon future growth rates. Changing investor perceptions of growth will affect growth stocks more significantly."

When analysts slash their forecasts, it can have a far greater effect on a growth stock than it would on a value stock. Using the stock valuation formula of the late Benjamin Graham, Martin offers the following example to demonstrate the difference in value swings between growth stocks and value stocks:

Value Company
A value stock with $1 of earnings drops from a 2 percent growth rate to a 1.5 percent growth rate -- a decline of 25 percent in the growth rate. The following equations tell the story:

Before the drop: 8.5 + {2 x 2% (growth) = 4} = 12.5 x $1 (earnings) = $12.50 intrinsic value

After the 25% growth rate drop: 8.5 + (2 x 1.5% = 3) = 11.5 x $1 = $11.50

In this example, a 25 percent drop in the growth rate of a slow-growth value stock resulted in an 8 percent decline in the intrinsic value of the company -- from $12.50 to $11.50.

Growth Company
A growth stock with $1 of earnings drops from a growth rate of 10 percent to 7.5 percent -- also a 25 percent decline. The following equations illustrate how that 25 percent drop affects the value of the company:

 8.5 + (2 x 10% =20) = 28.5x $1 = $28.50
 8.5 + (2 x 7.5%= 15) = 23.5 x $1 = $23.50

In this example, a 25 percent drop in the growth rate of the growth stock resulted in an 18 percent decline in the intrinsic value of the company, from $28.50 to $23.50. That's decline of 10 percent more than the value stock.

What does that mean for smart investors?

Martin contends that the higher volatility of growth stocks can work in the favor of long-term investors who are counting on market volatility to buy their stocks at an advantageous price.
"You can count on repeated opportunities to purchase growth companies at prices which should earn a reasonable hurdle rate," claims Martin. "The history of growth companies suggests that stable growth is rare. More common is the company experiences accelerations and decelerations in growth rates."

The ongoing volatility of the stock market gives long-term investors an opportunity to build their positions slowly and carefully, says Martin, who typically spends up to three years or more to build a full position in a stock.

"Rather than purchase a large position at a single point in time, there are several advantages to building up a position over months or years," he writes. "Just as Rome was not built in a day, great companies and great stocks do not develop overnight. How you enter a stock position has a lot to do with how you exit the position. The practice of patiently building a position teaches the investor to be disciplined in holding the stock."

Building a position over time gives investors a chance to drill deeper in their analysis of a company and watch how management operates the company before they commit a greater share of their portfolio to that stock. "The analyst is looking at a snapshot in time of the company," explains Martin. "What the analyst cannot gain at first glance is knowledge of the management's ability to make real-time decisions. Buying a stock slowly allows the investor to gain real-time experience with a management team before that position becomes too large."

Let's say you want to invest a total of 9 percent of your portfolio in a certain stock. When the stock hits a level that meets your price criteria, you should start by purchasing the equivalent of 3 percent of your portfolio, with the intention of adding two more 3 percent positions over the next two or three years -- depending on market conditions.

This prudent approach sets up a win-win situation for the investor. If the stock declines, you've saved yourself from further losses and given yourself a chance to further evaluate the company and the stock value. If it quickly doubles in price, you've attained your goal of achieving a positive return on your investment -- although you might wish you had bought more shares.

"That's an opportunity cost," explains Martin. "An opportunity cost is not a real cost. No money is lost -- you've simply lost the opportunity to make more money. The real goal should be to avoid real losses -- the money lost from investing too much in a stock that later tanks. In fact, the fear of incurring an opportunity cost has probably caused investors more real losses than any other factor."

Contact Information

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    Evan Almeroth
    (612) 317-4114