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When it comes to investing, many look at past returns, decide and get in. While I think past performance is good part of the equation, we often overlook what those returns represent. It's important to know because performance is only the result, but it doesn't explain what had to happen to get there. Consequently, it almost seems like we are behind the 8 ball, investing in what already took place. Maybe instead of just inquiring about past returns, we should ask, "Is what I am investing in going to grow?"
What is Growth?
Growth, in this investing sense, is actively building revenue. If a company earns $100 last year and $125 this year, it grew by $25. It has a 25% growth rate.
To accomplish this, companies have to constantly find new markets, new products and new ideas to propel this growth. This motivation toward corporate prosperity comes from the markets rewarding higher growth companies with higher stocks prices. If you think about it, would you really want to pay more for a company earning 7% growth, versus one earning 14%? Of course not! So we pay more for faster revenue producing companies
It's easy to lose sight of this concept! Just because we have discussed what to invest in and when to invest, it doesn't mean we can just float freely for the rest of your investment days. The truth is that markets and economies change, and they change for one reason only - growth. And in this globalized economy, continued growth will not always come from where it used to, nor should you automatically expect to get the returns from where your parents did.
Segment Growth
Growth is important on every level. Even when investing in ETFs, I see better long term performance rewarded to certain segments of the markets simply because there is more growth from the segment.
For instance: If I know over time that "mid cap" (mid-size) companies grow faster than "large cap" (the largest) companies and are expected to continue to do so in the future, I'm going to invest more often in mid cap ETFs than large cap ETFs. Why? It is easier for a $400 million company to grow to a $600 million company, than it is for a $4 billion company to grow to a $6 billion company.
Industry Growth
But it is not always a question of size. Most times, growth is related to an industry. For example, I suspect in the future that growth from alternative energies like solar, wind and nuclear will outpace growth from slower industries like retail. While we all need clothes, we need clean energy more. We can always forgo the latest fashions to make sure we don't pay $10 a gallon at the pump!
Economic Growth
We can even go one step further and look at economic growth. Previously, I mentioned when we see the economy slowing, like in a recession, investing the market is not a good idea simply because we expect most public companies to have less revenue in the future (and we are not going to pay a higher price for less revenue.) Thus, the market goes down to compensate for less growth. So where do we go to seek out growth?
We can either look towards other markets, like bonds, real estate, currencies, commodities or just temporarily hold cash until we find that growth. Another option is to seek out growth from other world economies. Even though most economies are dependent of each other for growth, not all economies do as bad as the US when it slows down. Hence, diversification in broad based ETFs outside the US should be a consideration for any portfolio wanting to take advantages of faster growing economies, or protection from a weakening dollar.
Future Growth, Never Current Growth
Whoa, Nelly! Be careful. Investing in countries, like Brazil or China, could be even more dangerous than investing domestically. Why? Markets reward future growth, not current growth. So even though China grows at 10% this year while the US may only grow at 2%, China may slow to 7% growth next year.
Just like stocks are punished for their slow growth, the markets will more likely punish countries that intend to slow their future growth. So before you invest in anything, you need to determine what the future growth is. While no one can ever predict the future (or at least they are not telling), here are a few things you can do...
Where to Identify Growth
For Stocks and Industries: To identify growth specific stocks or industries, you can pick up a copy of Investor's Business Daily, or go to Yahoo! Finance, enter a stock symbol and look at the headlines and upcoming events, or you can go to Briefing.com's free section and search for a specific company's earnings. In all these cases, we are looking for companies that give guidance on future revenue and earnings. When we spot those companies that experience more growth than they did in the past, they should become possible candidates for you to invest in.
Newspapers like IBD really help out in determining future stock and industry growth. Keep in mind you are looking for an acceleration of growth. While I have done well when stocks have accelerated their growth from 20% to 25%, I have also lost money on stocks that had grown at 30% last year, but stated that their growth will slow next. This is a sure sign to get out, no matter what happened in the past.
For ETFs: But most prefer to invest in broad based ETFs, so spotting individual or industry growth is less important than economic and segment growth. Unfortunately, this is harder to identify because you may be dealing with an ETF mirroring an index of 500 stocks. In such instances, focusing on future economic growth is more important when making your investment decision. No matter if you are investing domestically or in Europe or wherever, you need to ask a few questions:
What is the long term past performance? While future performance is not indicative of past performance, I like to make the assumption that if things continue to grow like they have in the past they will continue to generate the same returns (unless I see the drivers from growth change). We can get information on long term past performance from your broker, AAII.com, Morningstar, ETF connect or your favorite website.
What is the expected future growth? This is as simple as asking if the US is going to grow like it had in the past. While I know you want quick and dry percentages from "experts," the truth is they are making assumptions that can change quickly. Not many experts accounted for a deep housing crisis back in 2005 that has drastically affected our markets. But that shouldn't drive you away from picking up the latest monthly finance magazine (Money, Kiplinger's, etc.) or going to your favorite website to get some quick insight into future economic growth from several legitimate sources
We don't need to be perfect, just well informed. Isn't your money worth it? And besides, using a Stop Program and knowing when to get out will go a long way to lessen losses. The object is to locate and generate healthy returns from investments that demonstrate growth by asking the simple question, "Is what I am investing in going to grow more than it had in the past."
At Cheaplee.com, we stick it to the man one penny at a time by showing you how to invest and grow your wealth, share tips to save money and help build a successful retirement plan in order for you to retire early. Learn to secure your future at http://www.cheaplee.com
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