Is Growth Hurting Your Investing Returns?
In all biological systems, organisms compete for resources. Whether that’s food, sunlight, space, reproduction, or even social position, organisms compete in some form or another.
Humans are no different. We compete for food, jobs, beer, living space, tacos, energy, and even our investments… just like any biological system in nature. Where things get a little different is how humans compete for these resources — we use money. The price of scarce resources can be bid up so high, that only the most successful humans can afford it.
While there’s plenty of criticism of “money” in this world, it’s a far better system than beating each other with sticks and rocks to see who’s the baddest mofo around.
This competition for resources generally works wonders for doling out the world’s goods and services — except when it comes to investing.
Competing for Growth
As investors, we compete with one another to buy the “best” investments. What metric is used to define best? Investors favor “growth rates” above all others. Higher growth rates mean higher share prices as a result.
Index investors aren’t immune from engaging in this behavior either — typically fast growth companies command premium spots in indexes. For example, the top 5 holdings of every S&P 500 index fund are high-tech growth companies that command premium prices — Apple, Microsoft, Alphabet (Google), Amazon, and Facebook.
There’s more to investing than just growth of course — investors must remember that investing works a lot like a parimutuel system. The higher the price you pay, the lower your return. As the share price continues to climb, you’ll pay a higher price for future earnings and realize lower dividend yields. This hurts investors by making them rely on future growth to justify extremely high share prices. What if those growth expectations never materialize?
Take for example — Netflix. It’s growing fast, and is part of the S&P 500 . The company currently trades at a PE of 222 and has a market cap of 120.8 Billion dollars. (Yes, really!) That’s a tiny earnings yield of 0.45%. Currently Netflix has 57 million subscribers.
How many times would the number of subscribers have to double for a current investor to realize a 7% earnings yield?
It would need to double 4 times . This would mean 912 million (nearly 1 billion!) subscribers at current levels of profitability.
Is this realistic? 912 million subscribers is A LOT. Netflix is currently the biggest online video streaming company, but the Amazon’s and Disney’s of the world aren’t just going to just roll over and die. There’s plenty of competition on the way.
Netflix is a perfect example of an investment being bid-up well BEYOND what seems rational.
Who’s The Greatest Fool?
Wait a minute — What if an investor doesn’t plan to hold Netflix shares “long term”? What if you don’t care about things like profitability and earnings yield? You simply want to sell at a higher price than you purchased.
In essence, this is The Greater Fool Theory. Investors that follow this strategy are share-flippers, not shareholders. This kind of investor only looks to capture growth momentum and then sell to the next “Greater Fool”. In theory at least.
The problem is — What happens if you’re the greatest fool?
Eventually the law of large numbers kicks in, and growth slows. Will you get caught holding the bag when everyone runs for the exit?
Everyone tells themselves “I know when to sell”, but in reality humans are notoriously bad at predicting the future.
Ask yourself — are you a shareholder or really just a share flipper?
The Best Investments Aren’t Always Growth Companies
What the investing press doesn’t tell you, is that you don’t have too chase growth to be a successful investor. Grow is only one part of shareholder return.
If you read my last post on February’s investing ideas, you probably noticed that NONE of my investing ideas were growth investments. A few of them might end-up seeing considerable growth over the long term, but none of my picks were the fast growers that attract the attention.
Why? I’m not willing to overpay for growth prospects. Growth is a guess.
Let’s also not forget how the world’s greatest investor earned his fortune — Warren Buffett, (easily one of the richest men in the world) got his start by buying garbage companies at very cheap prices. Now days, he’s well passed those days of cigar-butt companies, but he still buys companies where growth is slow.
Need more examples?
How about one of the most successful stock investments in the world? It’s Altria (aka Phillip Morris). Yes, the cigarette company! Despite being in a declining industry, Altria has managed to produce returns averaging 20.6% for the last 50 years!
Declining industries, slow growers, and unloved companies can make some of the best investments because they attract so little attention. In my opinion slow growth with a very long runway can be a truly a wonderful thing. These investments (mostly) get ignored by the investing public and will earn a much bigger “bang” for your investing dollar.
It’s Cultural
Culturally, humans get excited about shiny new things and big changes. Fast growing investments gets so much more attention because they’re exiting — “Netflix grew subscribers by 20% last year!!” is a far more exciting headline than “Large bank earns slightly more than last year!!”
This “excitement sells” attitude is a cultural bias. We want to read interesting content, and good headlines sell newspapers (or get pageviews). The most exciting growth companies are always going to be on the front page (or whatever top spot on your favorite website).
This bias blinds us to the fact that popularity (at least in investing) is our enemy.
There’s been dozens of studies that prove this point over the years, but one of my favorites can be found in “The Future for Investors: Why the Tried and the True Triumph Over the Bold and the New “ by Professor Jeremy Siegel. It’s a great book, and on my list of recommended books for a reason. Check it out!
Timelessness
Rather than fighting over growth, I posit there is a better way to invest. Instead of fighting over growth, investors should focus on what’s timeless about our lives and cultures.
No matter how much new technology can change life, some things are never going to change:
- We’ll always have a need to borrow money, invest it, and store it in a safe place.
- Safe and affordable shelter will be required to protect us from the harsh environment.
- Energy (in some form or another) will always be needed to power society.
- People will always have an need for quick and efficient transportation both in the air (long distances) and on the ground (short distances).
- Humans will need to eat food produced at scale, due to large productivity advantages over individualized farming.
- And so on…
This idea is exactly why I own investments like banks, energy companies, apartment REITs, and airlines. Simply put, investor are better served by trying to capture the timeless qualities of human life rather than trying to capture what’s changing fastest about it.
The world is always changing, but change is often the enemy of investors. Few companies are able to successfully adapt to change over long periods of time. (“The Innovator’s Dilemma” covers this concept idea in incredible detail.)
Find and invest in what’s timeless instead!
Final Thoughts
All this isn’t to say that growth is a bad thing. I love growth! Growth can be a very good thing when it comes at a reasonable price. It’s just that reasonable prices are exceedingly rare unicorns in this lovely little world.
It’s better to not compete for scarce resources. Find overlooked investment areas, ignored by popular media. That’s where great long term investments are going to be found. If these are slow growth industries, that’s completely OK.
Sometimes it’s better to be more like the tortoise than the hare.
I think this is so true. Markets are so efficient, it is very likely you will over pay for the super growers. The experts already got there before you and pushed the price up. Sounds so strange to say “invest in industries on the decline” but it sometimes makes for good advice.
Yes, it does! Warren Buffett spent his life betting against change and overpriced growth. It worked out pretty well for him.
There is no real long term safety in those “safe” sectors. Farm production can be outsourced to other countries, meat may switch to test tube big pharma sources which could render domestic food stocks worthless. Utilities may lose out to home solar generation or some form of fusion, today’s car companies may replaced by electric car manufacturers or foreign competition, conventional apartment complexes might be replaced by yet unimagined living arrangements. At one point in the past safe investing logic had people invested in whale harvesting and buggy whip makers. It may be safer but there is no guaranteed sector strategy, which is one reason index funds are hard to out perform. They automatically cull the herd of bad performers.
Wow, you’ve really got a crystal ball there Steveark! Good luck to you.
I just like to argue, great post! It will be after our lifetimes before any of that stiff happens most likely. I’m not expecting a test tube T bone steak anytime soon.
Our friend told us yesterday that we bought some Amazon stocks when they were just $30 each and sold them when the price reached $40.
He wishes he had held on to them because they’re now almost $1,500 each. Who would have known? Amazon was just a small company back then. He’s now buying stocks at Groupon and other startups and is hoping for the same magic to happen 😀
That’s pretty funny, I be he’s kicking himself. The odds of reproducing such a winner are slim to none.
Great post! I like your Netflix example. Although some would say that if Netflix found a new way to monetize it’s existing 57 million subscribers, they don’t necessarily have to double or triple their subscriber base. Innovative ideas can play big in their strategy, vice continual subscriber expansion.
You think so? It’s possible. I mentioned in the post that this assumed “current profitability”. I really don’t think Netflix has that much pricing power.
I suppose they could start charging more for certain movies or tv shows — Sort of a super premium subscriber. Or, they could start introducing intermittent ads into their programing, like cable television.
At some point growth will slow, and investors will realize just how over valued it is. Disney itself is only worth 160 Billion.
Yeah, at current profitability they’re running out of room. And like you mentioned, Amazon is coming. I don’t think Amazon has yet to even take video seriously yet, it’s just an add-on to Prime they’ve been playing with.
I’m not saying I think Netflix can do it, just wanted to make the point that the best companies dig deep and innovate, and find a way. We’ll see if they can pull it off.
I think that the advice to ‘find and invest in what’s timeless’ is good advice at a thematic level.
It’s then a case of looking for the companies / indices that capture that which is timeless through the ages. Take the human need to communicate – that need has arguably been served from time to time by mobile phone manufacturers, telecom companies and social media networks. The same timeless need can be served in a number of different ways throughout time. The tricky part can be identifying whether the way in which a timeless need is being served is changing and re-allocating investment accordingly.
Yep. Asset allocation is a whole other topic however.
Mr. Tako – So do you consider yourself a value investor? Or something else?
I tilt heavily towards Vanguard Value Index funds (small, medium, and large) so I consider myself to be a value investor. They tend to stay away from popular growth stocks.
Mr. Freaky Frugal recently posted…The stages of FIREing
I’m very much a value investor. The definition of a value investor is (of course) subject to significant interpretation. 😉
I hold some Vanguard Value index funds myself.
You made a point I’ve been pounding the table on for awhile, index funds’ top holdings; there all the same! The top 10 holdings of most of the index funds are synonymous with one another, FAANG stocks! When the next, larger selloff occurs, in order to meet redemptions the funds will all be selling these liquid names at once. Kate, bar the door!
This is the risk of this vogue idea of indexing and passive investing and robo-whatever. It’s a bubble!
The only funds to be investing in now are actively managed funds run by very capable managers, the Oakmark Funds for instance. The Weitz Value family of funds is another example.
I’m not high on indexing. The idea of fee savings is overblown. The fees saved with index fund investing will take a backseat to Performance going forward in my opinion.
Yes- many books have shown that investors chronically overpay for growth. It does work out sometimes in certain companies but across the board, the strategy generally produces substandard results. Philip Morris was only a great investment since it was so unloved (sin industry, lawsuits, the correct prediction that smoking volumes will dry up) and the valuation was so low for so long. That gave the stock a high yield and made for excellent dividend and share investment which created a great increase in total return. So a case of not even low growth but just minimal negative growth coupled with very weak expectations.
I tend to invest along similar lines as you so you are already preaching to the converted 🙂
Amen brother! Can I get hallelujah? 😉
We are pretty boring index investors but my takeaway from reading a bit about investing is that people might do better tilting towards value and towards small. I suppose we do the latter with the No Brainer portfolio, but nothing at all re: value.
Still, I really like the post as it shows that growth ain’t the end all, be all.
“Fast growing investments gets so much more attention because they’re exciting”
True. People love shiny new things and our impatience make us want stocks that give us big returns. But in reality, investing needs to be boring–as boring as possible. Instead of relying on luck to knock it out of the park, the real way to win is slow, consistent progress without shooting yourself in the foot. That’s the key to successful investing.
Couldn’t agree more FIRECracker. Investing should be like watching paint dry. A satisfactory result, but an uninteresting process.
Fantastic post, Mr. Tako Escapes! This pretty much sums up how I’ve been feeling lately with all the bitcoin and marijuana “investor” noise going on. It seems as though most people think the only way to make money from investing is to pick growth stocks. Mean while, I just keep sticking to my “boring” bank and utilities stocks. With respect to your points about share flipping, I quickly found out that selling always made me feel uncomfortable, regardless of how great the return was. There is almost never a perfect time to sell, and you usually continue to follow the stock and regret selling it anyways. I much prefer the slow, more predictable growth of solid dividend growth stocks. Thanks for sharing!
Reverse The Crush recently posted…Prioritizing Investment Expenses Is Grossly Overrated—Paying Per Trade Is King
Thanks RTC!
Mr. Tako,
Relatively new to your blog. I am impressed with your dividend income level. It just goes to show that consistent saving over a period of time (along with compounding effects) really adds up over time. Congratulations. Nice post as well. I learned the hard way back when internet stocks were taking off in the late 90’s that in most cases it was fools gold and did not work out real well. I learned an expensive lesson. What ultimately allowed me to get to financial independence is residential rental properties. Amazon has really hurt retail, etc. but everyone needs a nice, safe place to live. Amazon cannot take that industry over. Plus, unlike a stock, I have direct control of the overall performance.