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Isn’t growth the most important variable in a stock’s return?

Daniel E. Hutner, Sr.

Today, more than ever, investors are talking about growth as the most important determinant of a stock’s future return. It’s almost a cliché. XYZ stock is going to grow a lot in the future, which means that I’m going to make a lot of money. Or a sector like the biotech industry is going to grow a lot and make investors rich. Or a whole area of the world is going to grow, like emerging markets, or now, frontier markets.

Jeremy Siegel calls this “the growth trap” in his book The Future For Investors. As he puts it:

The growth trap seduces investors into overpaying for the very firm and industries that drive innovation and spearhead economic expansion. This relentless pursuit of growth – through buying hot stocks, seeking exciting new technologies, or investing in the fastest-growing countries – dooms investors to poor returns. In fact, history shows that many of the best-performing investments are instead found in shrinking industries and in slower-growing countries.

The reason: The return on a stock isn’t based just on how much the company grows, but also on what the investor pays for that growth. Generally, investors pay far too much for companies that appear to have attractive growth prospects, and underpay for companies that have lower growth potential.
Moreover, Siegel describes an anomaly in the stock market – similar to that discovered by Warren Buffett and Charlie Munger, Cliff Asness of AQR Capital management, Chuck Joyce and Kimball Mayer at GMO (Profits For The Long Run: Affirming The Case For Quality), and a number of researchers – where the growth prospects for very high-quality companies aren’t properly priced. Unlike companies that have poor prospects, high-quality companies often appear to have a pretty high price. But Siegel, and these other experts, have all noted that given their quality, this price has consistently not been high enough.
The result, as I’ve written before, is an investor nirvana – what Siegel calls investment “El Dorados” – where you are getting high returns with much less risk.
As an example of these high potential returns, Siegel cites a study he did to see which of the original companies in the S&P 500 had the best stock market performance since its inception. What he found was that two industry groups – consumer non-durables and pharmaceuticals (including well-known over-the-counter products) far outperformed all the others:
In fact, eleven of the top twenty are well-known consumer brand stocks. Two others of the twenty best-performing stocks also manufacture products virtually unchanged over the past 100 years: the William Wrigley Jr. Company and Hershey. What is true about all these firms is that their success came through developing strong brands not only in the United States but all over the world. A well-respected brand name gives the firm the ability to price its product above the competition and deliver more profits to investors.
These slower growing brand-name firms accounted for 85% of the twenty top performing companies in the original S&P 500.
Berkshire Hathaway recognized this phenomenon early on. As Charlie Munger has said:

We’ve really made the money out of high-quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyze what happened, the big money’s been made in the high-quality businesses. And most of the other people who’ve made a lot of money have done so in high-quality businesses.
— Charlie Munger, USC Business School, 1994

Another advantage of these high-quality companies is that they generate cash rather than consume it. That cash can be used for growing dividends and stock repurchases, both of which enhance the value of your shares. On the other hand, a company can have high revenue growth but end up consuming all its cash to fund its growing operations (think Amazon or cash-burning internet startups) – and never really become profitable.

Of course, the investment world tends to talk about revenue growth when stock prices are high and it’s hard to justify prices based solely on earnings. As in, “this company may not seem cheap but think of how much its revenues are growing.” Then, when companies are even expensive based on revenue growth, the line is “think of how much potential growth there might be.” There is likely to be less than you will be paying for.