Capital growth is one of the main reasons for investing in stocks.
Many aspire to attain it. But, few understand how capital growth is attained sustainably. Because of this, most were confused as to how it is attained. Such confusion led many to focus on charts, volumes, trends, news, macros, predictions, pundits, and so on to trade stocks. The confusion is made worse when they believe that what they do is “investing”, which in reality, could be trading, gambling or speculating.
So, what does the few know about attaining capital growth?
The few aren’t just exclusive to billionaires like Warren Buffett. They also included ordinary folks, including Ronald Read and Grace Groner. Read was a janitor who had left behind a hefty US$ 8 million estate, consisting of almost 100 stocks, to his local library, hospital, family and friends. As for Groner, she was a secretary, who bequeathed US$ 7.2 million to her foundation. These folks, as ordinary as they can be, amassed extraordinary wealth via capital growth from their stocks.
If you believe that you need superior intelligence to attain wealth, think again.
In this article, I’ll just touch on how “extraordinary” capital growth can be attained in the long run. To do this, I’ll share 2 types of capital growth in stock investing. Of which, I would share which of the 2 types investors should focus on as that can bring sustainable capital growth, thus, allowing us to amass wealth.
Type 1: EPS Growth
EPS stands for earnings per share.
So, if a stock earns $10 million from its businesses and has 10 million shares in Year 0, the EPS of this stock would be $1. Assuming it maintains its number of shares and the stock continues to expand its businesses, thus, increasing its earnings to $20 million in Year 5. As such, the stock’s EPS in Year 5 would be $2.
In practice, investors would value stocks based on their ability to generate income.
From the above example, investors would value the stock based on $1 in EPS in Year 0. But, as for Year 5, they would revalue the same stock at $2 in EPS for its ability to generate income had improved in that 5-year period.
Type 2: Changes in PE
PE refers to P/E Ratio.
Let’s continue with the example above and assume that for most periods throughout Year 0 to 5, investors are willing to invest around 20 times its EPS (P/E Ratio of 20) for this stock. Hence, for Year 0, the stock is valued to be $20 (20 times of $1 in EPS). At Year 5, the stock is valued to be $40 (20 times of $2 in EPS).
However, most people in the stock market are traders and speculators.
They don’t think like investors. They are in and out of stocks for the short-term. This had and will cause the stock market to be volatile in the short run. Let’s say, they believe that the stock has a positive outlook and will rise in price in the immediate future, they may buy the stock. This would cause its stock price to be trading at a higher PE than usual of 20. So, let’s assume at Year 5, its stock price is $50. The PE of the stock is 25. Hence, the excess PE of 5 is a “change in PE” and this type of capital gain is attributed to more short-term demand from traders and speculators.
Of course, the opposite can happen too.
Instead of optimism, what if there is a crisis that causes many to fear entering the stock market? It’s like COVID-19 in 2020. This causes its stock price to be trading at a lower PE than usual. So for the stock above, what if its price tumbled sharply to $30? The PE of the stock is 15. Hence, it is a “negative change of PE” and such may cause either lower capital growth or capital losses to shareholders, at least for the short-term.
Which to Focus On?
In brief, capital growth = EPS Growth + Changes in PE.
In most cases, EPS Growth is the main contributor to sustainable long-term capital growth, thus, is the focus for stock investors. Personally, I like to focus on EPS Growth as it is simple. To me, I find it logical for stocks to grow in value over time if their businesses are expanding and are able to deliver continuous growth in revenue, earnings, and operating cash flows over time. It is more or less similar to investing in a property where you could increase its annual rent for 5, 10, 20, or more years to come.
Put it this way. Let’s assume you bought a property in KL for RM 200k in 2000. You had rented it to a tenant for RM 1k a month at that time. Now after 24 years, you are raking in RM 3k a month from this property. So, will you sell off this property for RM 200k in 2024? Of course not.
The logic is applicable to stock investing. Take Public Bank as an example. In 2003, Public Bank generated RM 974 million in earnings. Its stock price was trading at RM 5+ a share (before a 4:1 bonus issue in 2021). After adjusting for the 4:1 bonus issue, its stock price was RM 1+ a share. After 20 years, Public Bank generated RM 6.12 billion in earnings, 6X what it earned in 2003. As such, is it practical to wait for Public Bank to drop to RM 1+ a share before investing in it?
To investors, “changes in PE” is an uncontrollable factor. It is not practical to predict what market participants, namely traders, speculators, pundits, … etc would react to certain events that could or could not impact a stock’s price movements in the short-term. Predictions are often futile. Just think about it. What works for most successful investors boil down to 2 main ingredients: Growth in EPS and having a super long-term holding period.
Back to Basics for Long-Term Capital Growth
In short, investing is best when the basics are prioritised. The basics is “Stock investing is about accumulating shares of increasingly profitable businesses for the long-term”. So, the main focus is to ensure the businesses invested have the ability to scale, expand, grow and deliver financial results like growing revenues, earnings and operating cash flows for the long-term.
This requires a combination of skill sets of accounting, valuation and portfolio management.
Here, if you intend to learn how to build a portfolio filled only with the top 1% corporations in the US, you may check out our free 1-Hour Online Webinar on Growth Investing as follows:
