The Secret to Growth Investing

According to data from the SPDR STI ETF (SGX: ES3), an exchange-traded fund which tracks Singapore’s share market barometer the Straits Times Index (SGX: ^STI), the average share in Singapore’s market is valued at around 14 times trailing earnings. In other words, the average price/earnings (PE) ratio in the market is 14.

Looking at the PE ratio alone, shares such as VICOM Limited (SGX: V01), Raffles Medical Group Ltd. (SGX: R01), and Dairy Farm International Holdings Ltd (SGX: D01) might be deemed as expensive. After all, they carry trailing PE ratios of 20, 26, and 28 respectively at their current share prices.

Source: S&P Capital IQ

For investors with a penchant for picking growth shares with a great operational track record, the trio would certainly qualify given their consistent and fast profit growth as shown in the chart below. But as the saying goes, there’s no share which is so good that it can’t become a poor investment at too high a price. What though, is ‘too high’?

The mother of all growth shares                                                          

To help with that, let’s turn the clock back to August 1974 and teleport ourselves to the state of Arkansas in the USA. At the start of that month, shares of Arkansas-based hypermarket retailer Walmart were going for a split-adjusted US$0.038 per share. In the company’s 1974 annual report, it was revealed that it was only present in six states in the USA – bearing in mind that there are 50 states in the country – and had seen remarkable growth in both its revenue and net income as shown below.

Walmart’s financials 1970 1974
Revenue US$30.9 million US$167.6 million
Net Income US$1.19 million US$11.9 million

Source: Walmart 1974 annual report

Now here’s a question: How much would you be willing to pay for Walmart’s shares if you wanted to earn a 15% annualised return from August 1974 till today? If we work backwards from Walmart’s current share price of US$74, we would land at a share price of US$0.278 back then. And, that would represent a trailing PE ratio of – get this – 150.

Try asking any notable investor worth his stripes if he’s willing to pay 150 times trailing earnings for a company’s shares to earn a 15% annualised return for four decades. He’d likely think you’re nuts.

It’s not a crazy world we’re living in

But with Walmart, there were signs that it might not be so crazy after all.

The first sign deals with Walmart’s Total Addressable Market, or TAM. Successful venture capitalists use this metric today to help them find the next big growth company, but the concept of TAM would still have been incredibly useful for an investor back in the 1970s. As a hypermarket retailer in the USA, a logical conclusion for the TAM of the company back then would have been literally the entire country. After all, regardless of where you live, you’d still need groceries and daily necessities. From that vantage point, the size of Walmart’s opportunity becomes evident – it only had operations in six states back then and had 44 more to conquer. Besides the geographical opportunity, the dollar figures were also staggering – in 1970, total retail sales in the USA for the month of February clocked in at US$25 billion. That’s in stark contrast to Walmart’s annual revenue of just US$30.9 million in the same year.

The second sign concerns the company’s ability to capture its TAM (having a big market isn’t enough, the company has to be able to make use of it), which is encapsulated in the table I showed above where the company managed to more than triple its sales in just four years. That’s a very strong signal of the strength of its business and its ability to conquer new markets. If we put both signs together, we end up with a conclusion that Walmart very likely had a tremendous run-way for growth which could justify what might seem like a crazy share price.

Foolish Bottom Line

Walmart might be an American company with a story that’s more than four decades old. But, the lessons within are still applicable even for us in Singapore today. As Winston Churchill once said, “The farther backward you can look, the farther forward you are likely to see.”

Some growth shares might be really expensive with prices that cannot be supported even by long-term business growth. But, there would also be some genuine highly priced gems which can still deliver great returns despite a seemingly expensive price. And, the key to determine if a share’s the former or latter, might just lie with the size of its TAM and its ability to capture the opportunity.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Raffles Medical Group.