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Course 405
Classic-Growth Stocks

Introduction

Classic-growth companies are the stalwarts of the investing world: If the S&P 500 were a stock, it would fit in the classic-growth category. While their growth rates aren't setting the business world on fire, classic-growth companies are growing respectably faster than the general economy and most pay a modest dividend. These companies are also generally mature firms that have relatively predictable, visible earnings. Unlike speculative-growth companies, classic-growth firms have plenty of profitability to go with their growth. Classic-growth companies are generally better established than speculative- and aggressive-growth companies, and they have a core business or businesses that are mature and solidly profitable. McDonald's MCD fits the classic-growth type to a T. Demand for its hamburgers and fries is steady from year to year, and its powerful brand name has helped it garner an impressive track record of growth for a company of its size.

How Fast Has It Been Growing?

McDonald's has posted solid growth rates. Its annualized three-year revenue growth through 1999 was about 8%, more than double the GDP (gross domestic product) growth rate. McDonald's isn't growing as fast as an aggressive-growth firm, but the tradeoff is that it should offer more dependability than higher-octane growers. That's why we'll start by scrutinizing McDonald's performance for signs of instability.

What Are the Trends in Growth Rates?

A big danger with a classic-growth company is that it may be reaching the end of the growth stage of its life cycle and will soon slip into the slow-growth category. That's especially true of a company the size of McDonald's, which boasts more than $13 billion in annual sales. It is possible that the company has saturated its flagship U.S. market and has little room to grow. McDonald's growth has indeed slowed down in recent years. Its year-on-year growth in revenue and operating earnings fell below 10% in the late 1990s, after being in the teens during most of the decade. On the other hand, revenue growth and cash flow both increased in 1998 and 1999, indicating that the company still has some kick left in it.

Where Is Growth Coming From?

Because classic-growth companies tend to have one or more businesses that are well established and mature, it is important to look at what segments are driving growth. It is possible that the mature segments are stagnating and that newer areas are responsible for overall growth rates. A less broad-based growth can make for a riskier investment, with the company's performance depending on the strength of relatively untried businesses. Worse, if the mature segments enter a decline, the growing businesses may not have enough size or horsepower to compensate. McDonald's growth is uneven. Over the past three years, overseas sales have accounted for an increasingly large portion of the company's overall revenues. The shift is even more marked in the breakdown of operating income. However, McDonald's still looks like it's in good shape. Even though growth rates may not be uniform across regions, a glance at the annual report shows that the comparatively slow-growing U.S. operations are still expanding at a respectable clip of around 5% per year. But McDonald's international business has been doing even better, with revenues rising by about 10% to 15% every year. Also, overseas operations now account for well over half of total revenues, so McDonald's slower growing segment has less effect on the company's overall growth.

Is Profitability Keeping Pace with Growth?

One temptation for classic-growth companies is to stoke growth by getting into businesses or markets that offer limited profitability. Because the businesses of classic-growth firms are more mature, there are fewer obvious avenues of expansion. Willy-nilly expansion can make the top and bottom lines grow--even if return on capital suffers. But maintaining shareholders' return on capital hasn't been a problem for McDonald's. Over the past five years, returns on equity (ROEs) have consistently been in the 18% to 19% range, and returns on assets (ROAs) have been just as steady. Returns on capital dipped slightly in 1998 because of a couple of one-time write-offs, but it bounced back in 1999.

What Is the Company Doing with Its Profits?

Unlike a high-yield or slow-growth company, classic-growth firms generally put most of their profits back into growing their businesses. If the company has a strong ROE, this is to investors' advantage since the firm is reinvesting the money at a high rate of return. The flip side is that payout ratios tend to be low and dividend yields skimpy. If the payout ratio of a classic-growth company is consistently high--say, more than 50% or 60%--it could be a sign that the firm is having trouble finding viable opportunities for growth. McDonald's is typical of the classic-growth model. With a payout ratio of around 15%, it is putting most of its earnings back into its business. That has been a good thing for investors, too. The company's ROE of 20% is comfortably higher than the median of 8% for all companies. McDonald's also performs well in comparison to the more-reliably profitable S&P 500 companies, which average an ROE of 15%.

Is the Company's Debt Leverage Increasing?

Classic-growth companies, with their solid and often noncyclical businesses, generally have a lot of room for debt. Reliable sales and operations mean that most of these companies don't have trouble making debt payments, so a high ratio of debt to equity is likely not a problem. Debt that is rising relative to assets or equity is something to look out for, however. For one, increasing debt means more volatile earnings because the larger interest payments on the debt magnify even small swings in earnings. Also, companies can prop up their profitability by taking on more debt leverage. Because financial leverage is one of the drivers of ROE, a firm can raise its ROE simply by borrowing more. Such a company may get a higher ROE, but the quality of that ROE will be lower. Worse, financial leverage can disguise a decline in net margins or asset turnover, the two other drivers of ROE that are more indicative of a company's operational health. As of late 1999, McDonald's financial leverage was 2.2, which is somewhat high compared to the classic-growth average. However, the company's level of debt has been fairly stable over the past five years, with financial leverage around 2.0. McDonald's debt level is not ideal, but neither is it a reason to worry.

How Has the Stock Performed?

Like the company's sales and earnings, McDonald's stock has performed quite consistently. It made gains every year from 1994 to 1999, often outperforming the S&P 500. In typical classic-growth-stock fashion, most of McDonald's total return has been from capital gains, not income. Because of their predictable and steady earnings, classic-growth stocks should be less risky than speculative-growth or aggressive-growth stocks. Looking at measures of past volatility, such as the worst three-month return, can give an indication of how risky the stock has been. McDonald's worst three-month return of -16% is significantly better than the classic-growth average.

How Do the Stock's Price Valuations Compare with Those of Similar Firms?

While classic-growth stocks typically don't command the sky-high valuations of aggressive growers, the market usually tags a premium on them because of their reliability. Looking at a stock's valuations relative to other stocks of the same type can be helpful in gauging the relative value of the stock. By traditional valuation measures such as price/earnings and price/sales ratios, McDonald's was somewhat on the pricey side at the end of 1999 compared with other classic-growth firms. To see how expensive McDonald's is relative to its growth rates, check its PEG ratio, or price to earnings growth, which indicates how much investors are paying for growth. This stock's PEG of 2.6 is also high for the classic-growth group, indicating that the market is expecting McDonald's to grow faster in the future than it has the past few years.

Conclusion: Quality versus Price

A price tag on the high side even relative to other classic-growth stocks doesn't automatically mean investors should pass on McDonald's. You would, however, want to consider McDonald's business in light of the price. Is it strong enough to be worth the higher risk implied by the stock's price multiples? McDonald's growth has been consistent, though slower in recent years. The company has managed its growth well, maintaining the return on investors' capital. McDonald's major growth catalyst, its overseas business, is no flash in the pan: It already accounts for more than half of total sales. McDonald's formidable brand name shouldn't be left out of consideration, either. It's difficult to assign a value to a brand name, but the recognizability of the golden arches has undoubtedly been a big factor in the company's success. Many classic-growth stocks have very recognizable brand names, which contribute to their value. On the other hand, a diehard value investor may conclude that McDonald's isn't obviously undervalued and therefore isn't a desirable investment. Neither answer is right nor wrong, because once you've weighed the business against the price, the final decision is whether the stock fits your investment style and risk tolerance.

Quiz 405
There is only one correct answer to each question.

1 In the corporate life cycle, classic-growth companies fit between:
a. Aggressive-growth and speculative-growth companies.
b. Slow-growth and aggressive-growth companies.
c. Slow-growth and speculative-growth companies.
2 Classic-growth companies typically:
a. Grow faster than the general economy, but they are not profitable.
b. Grow slower than the economy, but they achieve profitability.
c. Grow faster than the general economy, and they are profitable.
3 If a classic-growth company has a high dividend yield, it is usually a sign that:
a. The company is having a hard time finding new avenues for growth.
b. The company is extremely profitable.
c. Management expects growth to accelerate.
4 Classic-growth companies are typically less risky than:
a. Slow-growth and aggressive-growth companies.
b. Speculative-growth and slow-growth companies.
c. Aggressive-growth and speculative-growth companies.
5 Even if a company can easily make its debt payments, an increasing financial-leverage ratio can be problematic because:
a. Rising interest payments amplify the impact on earnings of even small revenue swings.
b. The company may have difficulties in raising additional capital through the bond markets.
c. Higher financial leverage ratios artificially inflate the quality of ROE.
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