Some Best Practices For Growth Stock Analysis On Seeking Alpha



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By Marc Pentacoff

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Introduction & Background

In the following we will discuss best practices for growth security analysis on Seeking Alpha. In the middle of the 1970s, Benjamin Graham, the acknowledged founder of value investing, was questioning the long term applicability of the specific value approach he followed for the last decades of his career. In the beginning of the 1950s, the Graham Newman fund was largely investing in net-nets and merger arbitrage. When Buffett joined the firm, an analysis showed their merger arbs business had successfully returned 20%+ per annum. It has been documented that spreads have fallen, bringing down returns with them. In the late 1960s and the 1970s, low risk value opportunities grew thinner, making building a portfolio more difficult – Buffett wound down his partnership in 1969 because of the dearth of opportunities. Despite a brief reappearance of value opportunities in 1974, said to have been the best value investing market before 2009, the value investing harvest, as originally practiced, grew thinner in US markets.

Furthermore, after decades of growth, it was clear that some investors had tremendous success purchasing firms at reasonable valuations and holding the firms over decades, although Munger has noted that some of the old Philip Fisher stalewarts eventually went into decline. Then Peter Lynch popularized growth investing in the late 1980s and 1990s, perhaps becoming the intellectual standard bearer of the growth investment strategy after Philip Fisher.

Graham began looking more closely at indexing in the sunset of his life, saying rather flippantly to students in the 1970s “that perhaps there was no safety but in growth.” But Buffett dismisses some of Ben Graham’s missives after he wound down his fund, for instance discounting the 4th edition of Security Analysis , published in 1962, which happens to have a 12 page chapter on growth securities. The 4th edition suffers from a lack of attention and from a collaborator with whom Ben Graham was allegedly too willing to compromise.

One challenge confronting the analyst is that growth investment is fundamentally more challenging and less teachable than value investing. There are more landmines which could, if stepped on, result in sickening losses since valuations which leave less room for error. It requires skill in business analysis and its corollary of industry analysis. No doubt it still requires a classic understanding of security analysis, implying that Graham’s Security Analysis , at least in the first three editions, will continue to be relevant no matter what one’s style is. Compared to value investing, it also involves more of an understanding about the state of the macro environment and appreciation of the major drivers of stock prices in general.

Good Growth Stock Analysis

To begin with, a good growth analysis will put the firm in proper context of its market, evaluating the firm’s prospects within this market. A good analysis will attempt to understand the financial results of these activities and value the firm based on its long term financial prospects, all with an eye to avoiding paying too much ahead of time for growth.

A growth analysis on Seeking Alpha does not need to be comprehensive – the below sections offer a plethora of relevant questions which would be bothersome for most readers to slog through question by question – however it does need to add value by extending the existing narrative around the security across one of the key domains, while not skipping information which is relevant given the current context of discussion and trading around a stock.

In simple terms, a good growth analysis will: (1) take note of the important growth statistics , in aggregate but also across products and segments and put them in context; (2) it will keep track of the evolving margins of the firm and its products or segments and whether these are in line with expectations and the firm’s plans; and (3) it will keep track of the firm’s longer term plans for products, strategy and management and assess the likelihood that the firm will achieve its plans. It will then (4) put the firm’s share price in context of its value and other investment opportunities.

The basic idea in terms of valuation is to present an analysis which demonstrates that the growth investor is not paying for too much growth in advance since this builds in conservatism within the analysis. The 4 basic discussions required in a good growth stock analysis, then, are:

  1. Growth , in aggregate and in products and segments

  2. Margins , in aggregate and in products and segments

  3. Quality of Products , Strategy & Management

  4. Valuation , absolute and relative

Basic Sections Of A Growth Analysis

For illustration, one way of organizing a discussion of a growth firm is to think of it as being built up in the following sections:

  • Product, Market Opportunity and Industry Outlook

  • Ongoing Development & Research Activities Of The Firm

  • Management & Strategy

  • Valuation

That is, products and markets are foundational; research and development activities are the material of which the future is made; management and strategy tie it all together; and reasonable valuation is required for conservative investment. We will walk through each of these, providing suggestions for topics to cover and consider.

Product, Market Opportunity and Industry Outlook

Questions to consider:

  • What is the firm’s product or primary revenue opportunity?

  • How do the firm’s products compare in the market? Who are their most critical competitors?

  • “Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?” (Philip Fisher’s Point #1)

  • “Does the Company have a worthwhile profit margin?” (Philip Fisher’s Point #5)

  • “Are there other aspects of the business, somewhat peculiar to the industries involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition?” (Philip Fisher’s Point #11)

All success comes from having a successful product and all growth comes from having a product which can either take market share or which sells into a rapidly growing market. Continued growth over a few years requires a product which has a long runway to take share and therefore the scale of a growth firm’s market share is important.

Equally important is the nature of the product and the nature of the industry. Does the product command a healthy profit margin? Does the nature of the product encourage regular or habituated use? Does the product generate goodwill and thus recurring purchases, etc.? What about the specific nature of the products and market may allow the analyst to judge the relative quality differences between this firm and another firm? In some industries one can simply look at product reviews and other assessments but frequently an analysis of the nature of the product and market will reveal how much confidence one can place in the continuation of the relative status of products within the industry.

Ongoing Development and Research Activities of The Firm

Questions to consider:

  • What products are being introduced in coming quarters or years? E.g., what products are in the works?

  • What is the size of the end market for these products?

  • Has the firm discussed its longer term product strategy?

  • “Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?” (Philip Fisher’s Point #2)

  • “How effective are the company’s research and development efforts in relation to its size?” (Philip Fisher’s Point #3).

  • “Does the company have a short-range or long-range outlook in regards to profits?” (Philip Fisher’s Point #12)

Even if a product has a large market to conquer, and therefore a sufficient runway, it is important to understand if they are continuing to develop their core products and revenue opportunity or if they are working to expand into adjacent industries, to sufficiently extend their runway for growth. One of the favorite ways shorts approach shorting a growth firm is to understand when their growth will slow due to product maturity or saturation. The opposite of this, therefore, is of interest to a long term investor in growth securities: is the firm turning out new products or evolving their existing products to continue to gain share or enter new markets?

Furthermore, how does the firm balance growth and profitability? Does the firm discuss and manage the trade off and successfully make investments which may hurt near term revenues if necessary? Philip Fisher suggests looking at the way firms treat their customers and vendors to see if they are looking to develop and build up long term economic goodwill, which may at times result in weaker near term profits.

Management Quality

Questions to consider:

  • What do you think of management’s ability to lead the firm, communicate its strategy, and to channel the energies of the firm’s sales and development organizations into profitable products and businesses?

  • What light does research shed on the firm’s culture?

  • “Does the company have an above-average sales organization?” (Philip Fisher Point #4)

  • “What is the company doing to maintain or improve profit margins?” (Philip Fisher Point #6)

  • “Does the company have outstanding labor and personnel relations?” (Philip Fisher Point #7)

  • “Does the company have outstanding executive relations?” (Philip Fisher Point #8)

  • “Does the company have depth to its management?” (Philip Fisher Point #9)

  • “How good are the company’s cost analysis and accounting controls?” (Point Fisher’s Point #10)

  • “Does the management talk freely to investors about its affairs when things are going well but “clam up” when troubles and disappointments occur?” (Philip Fisher’s Point 14)

  • “Does the company have a management of unquestionable integrity?” (Philip Fisher’s Point 15)

In Andy Grove’s High Output Management , he makes the case that in situations where business decisions are complex, uncertain and ambiguous, the best way to establish control — to ensure that employees are making the best decisions for the firm — is to instill a good corporate culture. Usually, this starts from the top and therefore it helps to evaluate your impression of upper management: CEO, COO, CFO, CTO, etc., or executives in critical positions within the company. For instance, at times international expansion may be critical to the success of a firm and understanding the qualities of the executive fulfilling that corporate function may prove useful to the analysis. What has turnover been like in the upper ranks? High turnover is bad, a red flag, and a favorite tell for shorts. Notice the dearth of turnover at firms such as Berkshire Hathaway. How deep, as well, is the firm’s bench? Is the corporate culture articulated by management and lived by them?

Indeed the questions regarding management are the most numerous and this, of course, includes employee relations. How does the firm appear to its employees and to prospective employees? Perhaps a third of software industry competition, if one could partition it that way, is essentially competition for software engineers between firms and this competition is based, in part, of the quality of their labor relations.

This goes, as well, to the sales culture. Sales drive the whole engine. There needs to be a healthy connection and interchange between the sales organization and the research and development organization. “Outstanding production, sales, and research may be considered the three main columns upon which…success is based,” writes Fisher.

As well, what is the firm doing to shore up its industry position or to improve its long term profitability? Does management discuss long term profit improvements and the scaling of their cost base? Has management successfully been able to achieve predicted margin improvements? How good, overall, is the firm’s ability to predict costs and sales? As Fisher asks, “how good are the company’s cost analysis and accounting controls?” Usually one can find out about this through research and following the firm’s comments on changes.

For instance, Nutanix recently changed their business model and expect the change to negatively affect revenues by 5% – 10% in exchange for greater long term revenue certainty. Then they changed their estimate to be negative 10%. They just adjusted it again to negative 20%. While this doesn’t imply that the firm will not make good on its plans, it raises questions about their forecasting ability and overall financial sophistication.

Valuation

  • Based on an assessment of long term earnings potential, e.g., long term margins, and current revenues, where does the firm stand in relation to the market in general and other similar growth firms?

  • Ben Graham suggests looking at valuations as having an “investment” component and a “speculative” component depending on the level o f earnings and the growth potential being priced in – what is the relative amount of investment value to “speculative value”?

  • “In the foreseeable future will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders’ benefit from this anticipated growth?” (Philip Fisher’s Point #13)

Growth investing is not, in its essentials, different from value investing. When a bond is purchased, it should be because there is an ample margin of earnings over the fixed charges to ensure the safety of a bond. In traditional value investing in common stocks, stocks ought to be purchased because there is an ample margin of safety between the conservatively estimated intrinsic value, usually established on a stagnant basis, and its current market price.

In growth investing, the principle is no different, except the common stock is assumed to be growing in value overtime. As Graham writes, the margin of safety, “in the case of a common stock it should be represented either by the excess of calculated intrinsic value over the price paid, or else by the excess of expected earnings and dividends for a period of years above a normal interest return” ( Security Analysis 3rd Edition , p. 45).

But Graham is usually understood to be backwards looking, searching for security in the great stream of life which has passed. He says that the trend of earnings is a qualitative consideration, not a quantitative one. This conservatism is very likely a result of being chastened by the great depression, which he faced with an initial level of leverage at 1.44. The first edition of Security Analysis probably came to be because of his lack of sufficient income at that time. And again, he later repents and says that perhaps there is no safety in growth.

For us, the trend cannot only be qualitative – the future must be considered. But it must be considered conservatively – with, dare we say, a new flavor of “margin of safety.” For us, the margin of safety in growth analysis must be represented by an estimation of the future, and its growth, which is conservative, in each and every respect. That is, a future which estimates growth at a conservative level and long term margins at a conservative level – a level which the analyst believes is extremely probable to come to pass. If on these conservative grounds, it can be shown that the investment is competitive with other investments, then the investment may be a good commitment.

Philip Fisher’s Risk Scale

In the middle of the 1970s, Philip Fisher writes up a scale of investment risk. The simplistic summary is that one wants to invest in high quality situations with great outlooks but which are priced at PE ratios which do not reflect these characteristics – because, for whatever reason, the financial community is underappreciating the firm’s advantages. One wants to avoid, naturally, investing in situations with unattractive outlooks and which are priced well above those characteristics. For a more thorough discussion, we recommend our quick take of Philip Fisher’s Risk Scale .

As it happens, like in value investing, this approach will necessarily show that many growth stocks are fully valued and only a few growth opportunities are clearly below their conservatively estimated long term value. Usually, it can be shown that these firms are relatively undervalued, as well as absolutely undervalued, assuming conservative growth and conservative margins.

Ratio Analysis and Valuation Over DCFs

Valuing growth securities is an area of wide consequence which would be better to tackle in a different forum. In general, we would advise looking at firms from multiple angles and trying to keep the analysis as simple as possible, using ratio based arguments for value as opposed to DCF analysis. Ratio based analysis usually allow for greater comparison across securities. Usually stocks which are demonstrably undervalued on peer ratios, which also have a good growth outlook with great management and products, indicate situations worthy of closer inspection.

Basic Red Flag In Analysis: Assuming Too Much Growth

A growth investor might consider it a red flag if their growth analysis only makes sense after 8 to 10 years of growth, as this implies that distant growth is necessary to justify the current share price. The future is unknowable but at least we can stick our finger in the wind to estimate the next couple years. Beyond a couple years, the future is shrouded in the dense fog of uncertainty – we cannot ignore our ignorance here and must account for it through conservatism in projection. Large levels of growth in out years, if they account for too much of the initial value of an investment, represent a red flag that the analyst may be putting too much faith in a far distant future which may not come to pass. Philosophers and mystics love to compare our shared existence to a river: it is always changing. “You cannot step in the same river twice,” of course, but a river also meanders over time, floods and sometimes forms side bodies which later are cut from their own source and die.

As well, it is important to ensure that the growth required to justify a firm’s valuation makes sense in context of its end markets. This mistake is one of the most common on Seeking Alpha. For instance, if you assume a firm is going to grow for 10 years at a rate well above the broader end market growth rate, it is possible that a sloppy revenue projection could outstrip the market from which it must take share (and therefore be plainly impossible). Or it is possible that a market can only sustain a few years of rapid growth and that any projections at that rate beyond a few years will result in dangerous error.

Conclusion

In the above we sought to illustrate the points and questions which are best reviewed in a growth stock analysis on Seeking Alpha. The critical points in all growth analysis, at least superficially, are the following:

  1. Growth

  2. Margins

  3. Products and market

  4. Valuation

As noted, growth analysis does not need to be comprehensive but rather relevant and in context. If investors are questioning growth, an in-depth look at the growth outlook of different products is appropriate. If investors are questioning strategy, an in-depth look at their products, industry, customers, management and strategy is appropriate. If the question is margins – a study of their costs and revenues. If the question is valuation – a comparative study of past growth stocks in similar situations. The point is to emphasize relevance over comprehensiveness.

We also suggested considering the following topic categories as a potential organizational device and idea bank:

  • Product, Market Opportunity and Industry Outlook

  • Ongoing Development & Research Activities Of The Firm

  • Management & Strategy

  • Valuation

Ultimately, however, it is important to understand that the above discussion is not a prescription. What is important is providing the reader with sufficient context and, when elaborating the valuation for the firm and the attractiveness of the security, putting it all in proper context of the nature of the products and the nature of the firm’s end markets.

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Please share your comments and suggestions for improvements below. What do you believe is most important thing for successful growth stock investment and analysis? What would you like to see more of in terms of growth analysis on Seeking Alpha?

See also The Turtle Beach Short Trade Looks Far Too Crowded on seekingalpha.com


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


















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