Growth Stocks Can Be Great, But They Aren’t The Only Road To Riches
When building a long-term investment portfolio, it’s easy to be drawn to the excitement of high-growth stocks. While these companies can offer high returns, they are not the only road to riches, and they often come with significant risk and uncertainty.
Investing in the largest companies in high-growth sectors doesn't guarantee success; many will still underperform the broader market.
An alternative, and often steadier, path is to invest in mature, stable companies. While these investments may not keep pace with the best high-growth stocks, they are often individually safer because their business models are proven and less burdened by high investor expectations.
A Hypothetical Example: A Mature Business
Let’s consider a stylized example of a mature company, "John's Widgets," which has reached $10 billion in sales and $2 billion in net income. We'll assume its cash flow matches its net income, it pays this out as a dividend, and the stock's Price/Earnings (P/E) ratio remains constant.
Let's see what the 10-year total returns would be in five potential scenarios.
1. Poor: -2.06% annualized In this scenario, the business falls short, and revenues decline by 3% per year. If management fails to cut costs, operating profits can disappear entirely. This highlights that even with "safe" companies, the quality of management is critical if the business deteriorates.
2. Disappointing: 5.00% annualized Here, revenues and expenses are frozen. The stock effectively acts like a bond, returning no more and no less than its 5% dividend yield (based on a $2B profit and 20 P/E ratio).
3. Middling: 8.15% annualized In this more realistic scenario, the company increases its prices by the yearly inflation rate (e.g., 3%), and its expenses increase similarly. The stock performs like an inflation-protected note with a 5% real yield, resulting in an 8.15% annual gain. This is an agreeable outcome, especially given the likely consistency of the business.
4. Good: 12.88% annualized Here, revenue growth tracks inflation (3%), but management runs the business efficiently, growing expenses at only 1% per year. This modest cost-saving has a substantial effect, significantly improving profit margins and boosting the 10-year net income by 53%.
5. Great: 17.70% annualized In this scenario, the business achieves unit growth. Besides raising prices by 3% for inflation, the company also manages to sell 3% more widgets each year. The combination of the dividend, unit growth, and higher margins propels earnings and delivers an excellent return.
Final Thoughts
This exercise is simplified. In reality, mature companies also repurchase shares and reinvest proceeds into their business.
However, the model provides a useful economic rationale for why investors may wish to own such companies. Rather than chasing headlines, a long-term, diversified portfolio can benefit from boring, stable, and mature businesses that generate consistent returns. History shows that, over time, a typical mature business can post reliable returns, forming a solid foundation for any long-term financial plan.
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