An Investor’s Dream Stock Is Low-Priced With Years of Growth Ahead of It

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Business school classes routinely categorize products and for-profit services as progressing through predictable and distinct life stages: development, introduction, growth, maturity and decline. Companies’ fortunes depend on extending their products’ life cycles as long and as profitably as they can. Some firms focus on continually adding hot new products (think Amazon), while others focus their efforts on preserving their established franchises and the profitable position they have built over the years — tobacco companies and utilities, for example.

The complete product life cycle will only be a best-case scenario, not a guarantee. 

Mismanaged companies fail all the time and products frequently never make it past their development stage. Tesla Motors (ticker: TSLA) is a real-time business case study on challenges faced by companies introducing new products. Pharmaceutical companies live and die by the strength of their drug patents. 

The art and science of successfully managing product life cycles is a mission-critical function for management teams and has profound implications for investors. Product maturity dictates optimal corporate strategies and what investors should expect from those stocks. It makes sense for companies to burn cash when developing a new product but far less so if the product is at what might be the peak in its popularity. Companies with mature or declining products should be returning profits to their investors, who can either spend it or invest in stocks with better growth prospects. 

Executives are reluctant to admit growth is becoming challenging. Activist investors are quick to criticize mature firms that hoard cash and may attempt a takeover of the board of directors. That’s an extreme outcome, at least to the executives who will likely be canned. But the other effect of reaching perceived maturity and decline is equally unappealing to managers and investors and far more likely: The stock will fall as investors sell and look for the next hot growth stock.

But there’s still plenty of virtue (and value) in maturity.

Mature companies are safer investments than early stage growth companies. They usually have more predictable cash flow and react less dramatically to broad market declines. Mature firms typically pay higher dividends and are quicker to redistribute profits to shareholders through increasing those dividends or implementing stock buybacks.

The dream scenario is rapid growth and strong profitability. It can and does happen.

Companies with dominant products, effective management and an ability to prevent competitors from crashing their party can keep that going for many years. But growth investors should always remember even the best parties end. Eventually buyers’ preferences will shift, the company will be mismanaged or a competitor will find a new way to do the same thing cheaper or better.

The biggest stock moves often come from the market reevaluating a firm’s growth prospects.

That’s why earnings reports are watched closely; they provide hard data about stocks’ fundamental performance. It’s better to bail out early on a growth stock than to hold a com­pany about to lose its competitive advantage. The market is brutal on stocks that don’t meet growth targets. Stocks are priced according to their expected cash flows and it’s an easy choice between a stream of growing cash flow and one that’s either stable, declining or worse.

Companies’ financial reporting, press releases and executive behavior often telegraph slowing or declining growth. It’s a bad sign if demand is growing but the firm’s market share is declining. The same is true of management turnover, choosing to emphasize different financial metrics than long-established practice, or most of all, pursuing half-baked new product ideas that fail to leverage the company’s core expertise. There’s no need to panic if your stock misses quarterly consensus earnings numbers by a minor amount, but you should be concerned when the company makes that a habit or continually guides forecasts lower.

Once a stock has been, shall we say, repriced for its maturing products and management is acting to distribute cash to shareholders, it may once again be an attractive investment for more conservative investors. If you’re a stock income investor, your hunt for yield likely will lead you toward stable and mature companies. 

But don’t neglect growth altogether; stock profits can be spent just as easily as dividend income and your capital gains may be taxed at a lower rate than the ordinary income tax rates applied to stock dividends. The big reason, though, for including some growth in your portfolio is not leaving all the upside in a long bull market on the table for everyone else.

If you’re a growth investor “stuck” with a mature stock, according to the definition of “growth investor” you should regard your mature stock as a potential source of funds once it’s fairly valued by the market and you spot a better opportunity elsewhere.

Your goal should be to identify stocks with predictable growth ahead of them and buy them at attractive prices.

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This article was originally published in the June/July 2019 issue of BetterInvesting Magazine.

Sam Levine is a frequent contributor to BetterInvesting Magazine. He teaches securities analysis and portfolio management at Wayne State University.


 

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