part0008

There are many different ways to invest. None is intrinsically better or worse than the others, but I would always recommend private investors focus upon one main approach. That way they will learn more quickly and over the years become relatively expert in applying their chosen method.

A distinction is often made between growth and value investment, where the term ‘value’ usually implies a discount to net assets. It is, however, a simplistic distinction. I consider myself to be a growth investor but my technique is essentially one of seeking out value within my chosen universe of growth shares. I simply measure value in a different way from traditional value investors. I will go into much more detail in later chapters about how I calculate the worth of a share. For now, suffice it to say that my approach sees value in a share if, for a comparable level of growth, it is rated on a lower price-earnings ratio (PER) than the other companies in its sector or the average of the market as a whole. All other things being equal, the lower a PER is relative to a company’s growth rate, the more attractive I find the share.

The approach also provides a margin of safety, because if the market is not expecting much it will rarely be disappointed. Looking for value in growth shares provides a kind of investment ‘double whammy’: a short-term gain as the value anomaly is corrected and a long-term benefit from the compounding of earnings growth.

Investing in shares at a discount to their underlying net asset value can be a rewarding long-term policy. However, the results can be choppy as share price increases often depend on new management or takeovers, either of which may take several years to happen. Investing in asset situations can also be less tax-effective than investing in growth shares. Once a share price rises to the underlying value of a company’s assets, most value investors take profits and move onto other stocks. As the profit is realised, a tax liability crystallises and has to be paid.

In contrast, excellent growth shares tend to be retained far longer than shares in asset situations. As a result, the tax liability on a growth share remains as a kind of interest-free loan from the Government while the share continues to be held. Tax considerations and the investment ‘double whammy’ are two good reasons to focus on growth shares, but there are others, such as the sheer scale of profits that can be achieved over many years. Take the example of one of the greatest growth shares ever.

Coca-Cola was floated in 1919 at $40 per share, but within a year the price had dropped to $20 because of wild gyrations in the sugar price. Since then, we have been through the financial crashes of 1929, 1974 and 1987, a few major wars and a depression or two. In spite of all these vicissitudes, Coca-Cola has continued to grow remorselessly and, as a result, in early 1996 the original $40 investment, with income reinvested, was worth over $4m a share.

Growth investors will also be encouraged by the story of Anne Scheiber whom, after retiring from the US Internal Revenue Service, invested $5,000 in the stock market in 1944. When she died in 1995, at the age of 101, her $5,000 had grown to a fortune of $22m.

Anne Scheiber’s broker says that she concentrated on leading growth stocks with great business franchises – companies like Coca-Cola and Schering-Plough. She did not deal very often, running her profits which compounded at an average rate of over 18% per annum.

In America, there is a much larger number of companies with great business franchises – a form of competitive advantage that I will elaborate upon in later chapters. The American home market is far bigger than that of the UK, and some of the American franchises, like McDonalds, Coca-Cola, Disney and Microsoft, are so strong that they are now all over the world. With companies like these, investors can take a very long-term view.

In the UK, we are not so fortunate. Our home market is much smaller, so many of our domestic growth companies quickly reach saturation point. Nevertheless, a select number of UK companies have been real winners over the years. Rentokil, for example, has been a wonderful growth share; £10,000 invested in it 23 years ago would be worth £820,000 today. During the same period, £10,000 invested in Racal would have fared even better and would now be worth £1.5m, even disregarding the value of shares in Vodafone and Chubb that were given to Racal shareholders when those companies were spun off from their parent. In both cases, there would also have been a substantial and growing stream of dividends which, if reinvested, would have vastly increased the total returns.

If you failed to invest in Rentokil and Racal while they were in their infancy, you may feel that you have missed the boat. Do not despair – there are many other companies that are only beginning to show their paces. There is a good chance that a few of them will grow into the giants of the future.

The story of Coca-Cola, the way Anne Scheiber built her fortune and the UK examples of Rentokil and Racal show that the long-term gains of investing in growth shares can be enormous. Anne Scheiber’s experience also illustrates the power of compounding money. Her average return of 18% per annum may not seem to be startling, but at that rate money doubles every four years, and over 40 it transformed $5,000 into a very sizeable fortune.

For all these reasons, I recommend growth shares as a staple investment diet. The upside potential is unlimited and, with a few precautions, the downside risk can also be minimised. This book is about growth shares and their wonderful potential, but the method of share selection I will show you has many influences. Technical analysis, fundamental measures such as cash flow, together with other important factors such as directors’ buying, all add to the technique and make it a uniquely powerful approach to investment.

The question I am most often asked at conferences is ‘What do you think is going to happen to the stock market as a whole?’ and I am always reminded of J.P. Morgan’s answer to his liftboy. The young man had waited for a year or so to be alone in the lift with him. When the day came he asked the great man, ‘Can you tell me what the market is likely to do today, Sir?’ J.P. Morgan thought for a moment before delivering his verdict: ‘It will fluctuate my boy, it will fluctuate.’

The short answer is that nobody knows if the market is about to go up or down. Bull markets climb a wall of worry so, by definition, investors are usually anxious while they are in progress. Conversely, bear markets usually strike when, as Joe Granville put it, ‘The public is sleeping the slumber of confidence.’

There are usually a number of telltale signs of the market’s likely future direction and I have devoted Chapter 14 to them. Meanwhile, remember that investment in growth shares is much more a matter of selection than timing.

A couple of years ago, I read an interesting American study by CDA-Weisnberger which supports the argument for selection. It tracked the fortunes of two gifted men: Mr A who had the ability to time the market to perfection and Mr B who had always been fully invested in the best sectors. Both investors began with $1,000 on 31 March 1980 and by 30 September 1992, Mr A had been in and out of the market on nine occasions, timing each move to a nicety. His $1,000 had grown to $14,650.

However Mr B, who had always been fully invested in the best sectors, turned his $1,000 into $62,640. During the same period, a $1,000 investment in the S & P 500 would have grown to a mere $6,030. The results achieved by Mr A and Mr B would have been hard to emulate, but they do show clearly that selection is far more important than timing.

Since 1919, the UK stock market has beaten deposit interest by an average of more than 6% per annum. Most years, cash has been a depreciating asset, whereas the right growth shares have been appreciating assets that far more than offset the ravages of inflation. The main purpose of this book is to show private investors how to identify and select excellent growth shares and to ensure that they also know how to extract maximum profit from them by buying at attractive prices. Once investors become more confident about their powers of analysis in choosing shares, they also become much less worried about the state of the market at any particular moment.