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1 risk ASX shareholders forget about “growth stocks”

warren buffett

When you think of Commonwealth Bank of Australia (ASX: CBA), Greencross Limited (ASX: GXL) or GetSwift Ltd (ASX: GSW) does the word “growth” come to mind?

1 risk ASX shareholders forget about “growth stocks”

When I think of reasons to own shares, whether on the ASX, the US, European or Emerging stock exchanges, there are two things I come back to:

  • Dividend income, which accounts for around half of all long-term returns from the Australian share market; and
  • Capital gains

Capital gains usually come from increasing share prices, although you could make money from ‘shorting’ a company’s stock.

Despite the obvious appeal of dividend income, most investors think of capital gains as the way to get rich in the sharemarket. They might be right.

We’ve all heard of Amazon, Apple and, heck, even Commbank shares are up 1,100% since going public in the early 1990’s.

But what most people fail to understand is that the only way for a company to grow profitably and sustainably is if it has a competitive advantage.

Those three words (competitive advantage, profitably and sustainably) are vital to what I’m going to say next.

If a company does not have a competitive advantage it can only grow by ‘getting bigger’. It does this by consuming more capital.

You might be saying to yourself, “doesn’t ‘growth’ equal ‘getting bigger’?”

A company will see its share price rise if it gets bigger, but it will not necessarily mean it is more profitable.

For example, a company without a competitive advantage that earns 10% for every dollar it invests will be able to sustainably grow only if its cost of capital is lower than that amount.

Let me put it another way, if you buy an investment that pays you 10% but you must use a loan that charges you 10%, the only way your investment will grow is by getting a bigger loan.

In the stock market, the calculation gets a little more complicated but the theory stays the same.

A company like Greencross, the pet store company, does not have a durable competitive advantage in my opinion. Dog food from Greencross is the same as the dog food from Pet Stock. They may have a slight advantage with scale but the laws of capitalism say that over time, their competitive position will disappear.

Now, you could make money buying Greencross shares. As it grows its store count, increases the number of vets, etc., its profit will grow. Even if its price-earnings ratio (P/E) stays at 10x for forever, all it needs to do is increase the ‘E’ (earnings) for the share price to increase.

But, sooner or later, a competitor will emerge and Greencross’ profit growth will slow to a terminal rate.

Greencross is just one example — and it has proven to be a great investment. But its model is being replicated.

So what happens to these types of businesses in time?

Well, the long-run return you can expect from them will fall to a ‘terminal rate’. You can still make money, as I have said, but the key message would be this:

Be there for a good time, not a long time.

The same could be said of GetSwift or any other business without a durable competitive advantage.

What makes a company with a durable advantage different?

Well… the terminal returns.

A company with a durable competitive advantage, even if it is only modest, can continue to produce outsized returns without the threat of falling profit margins (read: growth that is profitable and sustainable).

And, importantly, if they invest within their competitive advantage often they can grow their returns without issuing more capital.

So, whereas a company without an advantage will see their returns per dollar of capital fall over time, a company with an advantage should at least maintain the return — even if only for a little while longer.

While Commbank’s competitive advantage isn’t perhaps what it used to be, it’s advantage has held its investors in good stead for over two decades. That’s why its yearly returns have handily beaten the market’s average.

Foolish Takeaway

Picking companies that are ‘getting bigger’ does not mean you are a good “growth” investor. Sure, you might make money. But, unless you are buying and holding companies with a durable competitive advantage all you are really doing is playing the greater fool theory.

Where to invest $1,000 right now

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*Returns as of February 15th 2021

Owen Raszkiewicz owns shares of Amazon and Apple.

You can follow Owen on Twitter @OwenRask.

The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of Amazon and Apple and has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool Australia owns shares of Greencross Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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