Interesting that Wayne explained the lack of validity of this approach directly on the conference call. I
Growth investing is predicated upon two mathematical outworkings of dominant valuation methodology:
1) after tax returns are supercharged by compounding holdings in equities 2) all else being equal, if companies generate a ROIC above WACC and that there is scope for reinvestment at the same rate of return, all incremental capital should be re-invested in the company.
When you model out this out mathematically, far and away the greatest influence on valuation is the growth rate, and substantial evidence exists that investors are over optimistic estimating forward growth.
The problem then boils down to: 1) how do you distinguish companies that are genuinely creating value (minority) from the impostors that are genuinely not, prior to accounting profits being seen in the P&L? 2) how do you mitigate for the risk you could be wrong
For 1) taking an outside view and segmenting out igh performing companies from the mean historically and figuring out the patterns these share help estimate eventual profitability when controlling for known variables such as growth rate, margin, industry.
2) is more complex. The best answer to 2) is to buy with a big margin of safety but it is becoming harder to do so when lots of smart investors have figured out this paradigm. You can control for risk at the portfolio level (which I have done here). And finally you can increase allocation the greater certainty you have on forward growth.
As this is overall pretty hard to do, I tend to only buy bigger positions when a substantial margin of safety exists.
SKF Price at posting:
19.0¢ Sentiment: Buy Disclosure: Held
