Let’s consider the implications of contracting profits growth in the context of taking compounding into account. A stock growing its profits at a 40% annual clip drops to a 35% rate which most investors are still comfortable with because it is still a lot faster than corporate profits growth of approximately 7% a year. The growth rate has declined by 13%. However, if you compound the new, lower rate of 35% over 10 years, you end up with 30% less profits than at the higher rate.
Most family office investors don’t understand this phenomenon or pay attention to it; we do and sell stocks with decelerating growth rates because we have observed that the P/Es of such stocks will decline proportionately more than the magnitude of reduction in the growth rate.
The stocks we have sold recently triggered by decelerating profits growth have underperformed the S&P 500 from the time of exit to date. Their growth rates are still far greater than corporate profits growth, but their P/Es are quietly adjusting to a lower level of expectations. The reverse of this paradigm is also true. Golden Eagle Strategies looks for profit acceleration given that P/Es expand more than proportionately when there are expectations of an increase in profits growth.
Family offices can use research to their advantage quite effectively once they understand how profits growth impacts portfolio allocation.
About the Author – Robert Zuccaro, CFA, is the Founder & CIO of Golden Eagle Strategies, LLC. Over the course of his 30+ year investment management career, Robert has managed market leading institutional portfolios and two mutual funds.