Why Growth Stock Investing Is Harder Than It May Seem

There are basically two reasons. The first is that many stocks exhibit "growth" characteristics for meaningful periods of time, and then fail to follow through. The second is that the handful of "true" growth stocks keep growing, until like Microsoft (MSFT), they become a proxy for a whole sector, and thereby become captive to the fortunes of that sector ; in essence, growth stocks "work themselves out of a job."

The fact is, aggregate earnings of the companies listed major U.S. indexes AVERAGE an annual growth of 5.5%, which is not impressive. That is in spite of the fact that they can grow at double digit rates for a longer time span than the horizons of most investors. How to reconcile the two observations?

The secret of the business cycle is that earnings FALL occasionally. In the past century or so, this has been one year out of five. That is NOT to say it will occur every once fifth year. It could be the second or third year after the last fall, or it could be the eighth or ninth. But it has been one of five, ON AVERAGE. And these drops are fairly large--20% on average.

So "knowing" that earnings will fall 20% in one year out of five, and assuming steady forward progress of X% in the remaining four years, how high does X% steady growth need to be so that the 20% drop in the fifth year brings you down to a 5.5% a year trend line? The answer is that X was a surprisingly high 13%, and that's four years out of five.

On the other hand, Warren Buffett's growth holdings, like Coke (KO) and Procter and Gamble (PG), can actually grow ten years out of ten, and (formerly, at least) at double digit rates, which is why he is successful in this regard. What are his secrets? 1) The company has pricing power over its main product (in the manner of See's Candy), giving it the ability to largely charge "what the market will bear." 2) This is reflected in a high return on equity (ROE), giving it a strong "margin of safety" in its profitability AND growth potential. 3) The company is well diversified productwise and/or geographically so weakness in particular markets cause only limited damage.

But Buffett did warn: "Eventually growth forges its own anchor."

About ten years ago, an analyst asked the CEO of Nokia (NOK), one of the world's three largest cell phone companies, "Can you maintain your historical growth of X% for another ten years.?"

Without thinking, the CEO answered something like, "Sure, no problem."

Whereupon the analyst went back to his desk and calculated that in order to maintain the historical growth rate, there would by now (2010), have to be seven billion handsets, more than one for every one man, woman, and child, all produced and sold by Nokia.

Beyond a certain size (as when you are one of three major companies whose market share totals over 90%), the "hypergrowth" percentage gains that characterize even medium sized gains are no longer sustainable, because they are being taken off progressively higher bases.

In the middle of the past century, IBM could grow at 20% a year for about 20 years. Microsoft did even better for a shorter period of time. But it's also true that "trees don't grow to the sky." Or else the sales of IBM or Microsoft would eventually account for all of U.S. GDP, and more.

Disclosure: Long BRK.A; NOK