Tuesday, March 28, 2006

Investing In Growth Stocks Is Not For The Faint Of Heart

It seems like everyday we are inundated with stories about the next hot growth stocks. For example, people like Jim Cramer have made careers pontificating about the next high-flying stocks and the hottest industries in which to invest. Wall Street loves growth stocks when they are appreciating. For example, the stock market bubble of the late 90s was primarily due to the appreciation of growth stocks. The bubble was highly concentrated among large company growth stocks in general and technology growth stocks in particular.

I don't doubt that there was a lot of money to be made in growth stocks during the late 90s. However, when the actual growth of the underlying companies slows (which it inevitably will), the growth stocks take a beating. Take Cisco (CSCO), the technology bellwether, for example. In the late 90s there were several years when CSCO's PE ratio exceeded 100! After the bubble burst, however, CSCO's earnings took a hit and CSCO's stock price fell from the upper 70s in April 2000 all the way down to about 8 by October 2002. Its stock price has since recovered to about 21 and its forward PE ratio is about 18 right now. However, it stock price experienced an extreme PE compression once the growth ended in the late 90s and its stockholders have taken a bath even though earnings are much higher now than they ever were during the bubble.

This is precisely why investing in high PE growth stocks is so risky - they often continue their upward ascent until the day arrives when an earning target is missed or earnings growth slows. It is not atypical for these stocks to then lose 20+% almost immediately as the market digests the news. The moral is - if you are going to invest in growth stocks be prepared for volatility and be ready to sell if the market really turns on them.

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