Welcome to last part of The Motley Fool's '5 Steps to Better Investing' series.
We've touched on a couple of the mental and emotional challenges in investing, with Step 1, 'You don't have to make it back the way you lose it', and Step 2, Be Patient . We then addressed some of the ways in which your investment can go south in Step 3. Step 4 was a reminder of perhaps the greatest phenomenon investors have at our disposal in compound your dividends.
To round out this series, we'll have a look at one of the best ways to allow that compounding to take effect.
Step 5: Growth matters
Many an aphorism starts with 'there are two types of people…', and investing has its share. As a form of shorthand, investors often characterise themselves as being primarily driven by technical or fundamental analysis, having a growth or income strategy, or as value or growth style investors.
Labels can be useful in allowing us to communicate in shorthand – they save hours of explanation from first principles each time. Of course, labels can lead to broad generalisations that don't do justice to the nuances of a particular approach. They suffice for a high-level description but as always, the devil is in the detail.
Moving beyond labels
Whichever philosophical camp you end up in, I want to make the case for growth. Not Growth with a capital G, as an investment style, but the simple requirement for a company to find ways to increase its earnings year after year at an attractive rate before it earns the right to your investment dollars through a purchase of its shares.
No matter what investing style you subscribe to, growth is an important component of your investing success – as is the price you pay. This idea – that 'growth' and 'value' can co-exist – has even spawned its own label. There are various versions, but the one I see most regularly is 'growth at a reasonable price'.
As a label, it carries its own generalisations and interpretations, but as a concept, we can take some valuable lessons.
From little things, big things grow
Almost all blue-chip businesses began life as small businesses. Whether the first Westfield (ASX: WDC) shopping centre, the first mine of the Broken Hill Proprietary mining company (better known to us today as BHP Billiton (ASX: BHP)), the fabled Silicon Valley start ups such as Microsoft (Nasdaq: MSFT) or Apple (Nasdaq: AAPL), each of these companies was once quite small.
Now hindsight is always perfect, and I'm not suggesting for a second that any of these companies were slam-dunk certainties in their first year.
On the flip side, the days of hyper-growth are now probably well behind these businesses.
Trees don't grow to the sky
The reason is that size becomes its own anchor. When Westfield had only one shopping centre in its early days, the business could double in size overnight just by opening a second. These days, the company would have to open 124 new centres, to achieve the same instantaneous result.
The BHP of the early 1900s was small, enterprising and the world was its oyster. In 2012, as one of the largest miners in the world, there aren't too many untapped commodities or markets left for the Big Australian to exploit.
I think investors are likely to do reasonably well over the long term from a portfolio of solid, well-known blue chips – especially with many trading at pretty fair valuations at present. Most of these companies will continue to grow moderately, but they are increasingly looking for mergers or acquisitions to deliver cost savings in the absence of significant revenue growth.
Small is beautiful
Instead, significant growth is likely to come from the smaller end of the market – businesses that are tomorrow's Woolworths or Apple. In no small part, that's simply because the size of the opportunities in front of them are massive, compared to the currently small sizes of the companies.
So-called small-cap companies are often less researched and more prone to share price volatility. They are also less insulated from external shocks such as competition and economic conditions, and often have weaker balance sheets. For every Woolworths or BHP Billiton, there will be others with similar hopes in the same industries that have fallen by the wayside.
Investing in small-caps requires a little extra work, but also carries the potential for greater reward if you can get in on the ground floor (or even the first or second floor) of the ride. By the time you've reached the penthouse, the ride is over. The view may be spectacular, but by that time, the price tag is similarly hefty.
I'm not advocating an abandonment of large cap blue-chips for a second. What I am saying is that the smaller end of the market can be a very profitable place to go prospecting if you're prepared to do the work.
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Scott Phillips is The Motley Fool's feature columnist. Scott owns shares in Westfield Group, Westfield Retail Trust, Microsoft, Woolworths and Amazon.com. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.