Investors generally classify stocks into two broad categories - value stocks and growth stocks. But we are of the opinion that such a classification exists only in the mind. Value and growth in our opinion, cannot be separated from each other. We believe that they are joined at the hip. However, this discussion is for another article. Here, let us assume that value and growth stocks do in fact exist.
In a fast growing economy like India, most stocks tend to be classified in the 'growth' category. This is especially true for stocks from sectors like auto, infrastructure, telecom, media, financial services, retailing, FMCG, pharma, and realty. Or practically almost all major sectors of the economy!
A lot of companies from these sectors are growing by leaps and bounds. Some have also made their shareholders rich in the past. But will history repeat is questionable! Will all companies from these sectors continue to grow fast in the future? Will these be able to provide good returns to their shareholders in the future?
When you look around at the huge opportunities that the Indian economy presents to companies from these sectors, you might believe that good times will definitely follow them. You might also believe that, you as an investor will end up making tidy profits from them over the long run. These beliefs are given, we think. After all, it's normal to expect good returns from stocks if companies are growing fast.
Right? Probably not!
The thing that matters in the long run in not growth in earnings, but the quality of that growth! A company can grow its earnings by simply cutting its prices and trying to grab a larger market share. A company can also grow its earnings by expanding aggressively using borrowed funds or diluting equity. But whether such a growth is profitable for the investor is doubtful. Of course, it can be a profitable in the short run as the stock might rise on 'expansion' news. But over a long term, a company has to improve the quality of its earnings to be a real rewarding investment for an investor.
Let's now come to what's wrong with India's growth stocks. It's the country's entrepreneurial spirit! Confused?
Well, in simple terms, a growth opportunity in India does not last for long as many new players are quick to enter the fray and be party to that growth story. So you won't have one auto company that will continue to grow and the others in the sector that won't. Or for that matter, one infrastructure company that will bag all orders and won't face any competition.
We are not saying that 'competition' is true only for the Indian economy. We are just talking about the intensity of competition that most growth sector companies face. Be it high competition for new mobile subscribers. Or be it high competition for new small car buyers. Or for that matter, a high competition for the next bank home loan borrower.
In such cases, while companies grow their earnings, most are able to do this only by way of price cuts. And like all price wars, the end result is a lot of blood-shed. Some companies come out stronger from such price wars, but they emerge with such damaged balance sheets that getting into the growth mode again is really difficult.
Given this, should you not buy stocks of growing companies at all? We don't believe so. Identifying the right kind of growth companies - that have competitive advantages over their peers, and are more focused on maintaining the quality of their earnings than market share - is the way to go. It is also to remember that all companies in growing sectors won't fit these criteria. Thus, the search will be difficult.
But if you are able to zero in on a quality opportunity and long term growth in earnings, handsome rewards will come to you in the long term.
So, look around you. Deeply research the opportunities you like at first glance. And invest with conviction in the stocks that you think fulfill the quality criteria as we've discussed above. You never know, you might come face to face with an opportunity like Infosys was in 1993!