Growth investing: paying up for businesses expected to expand

The idea

A growth investor is not looking for a bargain. They are looking for a business that will be substantially larger in five or ten years, and they accept that today price already reflects some of that expectation.

The logic is straightforward. If a company grows its profit at 25% a year for a decade, its profit becomes roughly nine times larger. Paying a full price today for that outcome can still work out very well, because the business you own has fundamentally changed size.

The kinds of businesses this describes tend to share features: a growing market rather than a fixed one, some advantage that stops competitors copying them, the ability to serve more customers without proportionally more cost, and often a founder still running the business.

Why you always pay a high price

This is the uncomfortable structural fact of growth investing. If a company is obviously growing quickly, everyone can see it, and the price already includes that expectation.

So you are almost never buying growth cheaply. You are making a specific bet: that the growth will be larger, or will last longer, than the price currently assumes. That is a harder claim than it sounds, because you are disagreeing with a market that has the same information.

What happens when growth slows

This is the specific risk of growth investing, and it is worth understanding as arithmetic rather than as a warning.

A share price is roughly the profit multiplied by the PE ratio people are willing to pay. In a growth company, both numbers depend on the same expectation.

The profit fell 10%. The share price fell 55%. That is because the market did not just mark down the earnings, it also decided this was no longer a fast growing company and stopped paying a fast growing company multiple.

This is why growth shares fall so violently on results that are merely disappointing rather than disastrous. In a value position the multiple was already low, so there is less of it to lose. In a growth position, the multiple is a large part of what you paid for.

Growth or value?

These are usually presented as opposing camps. It is more useful to see them as two different bets about where the mistake is.

Neither approach works permanently. Market conditions favour one and then the other, in cycles that are only obvious afterwards. Investors who commit hard to one style typically abandon it at the point of maximum pain, which is usually shortly before it starts working.

This is one more argument for a broad index fund as a default. It holds both kinds of company, and it does not require you to be right about which style the next decade will reward.

Specific cautions in Indian markets

• Small and mid cap valuations can become extreme. Enthusiasm for a growth story in a smaller company can push prices far past anything the business supports, and the fall back is severe.
• Check whether growth is real or acquired. A company growing revenue by buying other companies is a different proposition from one growing its existing business. The first can hide a lot.
• Watch the cash. Reported profit and actual cash generated can diverge for a long time. Growth funded entirely by raising more money is fragile.
• Founder dependence cuts both ways. A capable founder is often the reason the growth exists, and also a single point of failure.
• Be wary of narratives. A compelling story about the future is not evidence. Ask what the business earns now and what would have to happen for the story to be true.

And the general point that applies to both styles: never let a single company become large enough in your portfolio that being wrong about it changes your life. See risk management.