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Course 406
Slow-Growth Stocks

Introduction

Slow-growth companies are just what the name implies. These are companies that have increased their sales and earnings over at least three years, but at less than the rate of GDP (gross domestic product) growth. Slow growth is not necessarily a stigma. Many companies in this category are remarkably consistent, posting rising earnings year in and year out, and that dependability helps compensate for their slow growth. Most important, any company, no matter how slow growing, can make a terrific investment if the price is right. Procter & Gamble PG fits the slow-growth mold for two reasons. First, it's big. Aside from phenomenal companies such as Coca-Cola KO or Microsoft MSFT, few companies with annual sales pushing $40 billion can consistently post rapid profit growth. Eventually, companies exhaust their best investment ideas, and the law of diminishing returns sets in. Second, P&G operates in industries--cleaning and food products--that are mature in the big markets of North America and Europe.

How Fast Is the Company Growing?

Procter & Gamble is no fast grower. The company increased its sales at an annualized pace of 2.6% between 1996 and 1999, though its earnings growth was better, at 7.5%. Both of those figures are well below the market average. To analyze P&G's performance more closely, we'll focus on dependability and profitability--two areas in which even slow-growth companies can excel.

How Consistently Is the Company Growing?

Consistency is valuable. A company that increases its profits by 10% every year is usually more attractive than a company that increases earnings 20% in some years and 0% in others. You know what you are getting as an investor, and there is less risk of price swings if short-term results don't meet expectations. Procter & Gamble gets high marks for consistency--or at least it did until recently. Its year-on-year growth in both revenues and earnings have ranged only a couple of percentage points in either direction from its three-year averages. That's remarkably consistent. However, note that P&G's earnings growth has been slowing down, from 16% in 1996 to 9% in 1999 (excluding a one-time charge). In March 2000, the company announced that its earnings for the year would fall far short of expectations, and its stock price plunged. That's what happens when a usually consistent performer like P&G stumbles.

Does the Company Generate a Dependable Stream of Free Cash Flow?

In addition to providing a steady record of growth, Procter & Gamble is a cash cow. The company consistently generates high free cash flows, sometimes (as in 1997) even surpassing its reported net income. Typically, with a slow-growing company, especially for a mature giant such as Procter & Gamble, the more free cash flow the better. A slow grower with negative free cash flows can become (or already is) a money pit, plowing more money into the business than the business is generating. Capital-intensive industries, such as steel and autos, are filled with such money pits. Procter & Gamble, by contrast, is producing real profit for its shareholders, and a lot of it.

What's the Company Doing with Its Money?

You would expect most slow-growing companies, especially those as big as Procter & Gamble, to be returning their free cash flows to shareholders. Unless a firm has explosive growth opportunities--and it's usually a good bet that a slow-growing company has few--the best place to park excess cash is in shareholders' pockets. Indeed, Procter & Gamble does pay out a significant chunk of its earnings as dividends. In 1999, the company paid about $0.40 in dividends for every $1.00 of earnings. Better still, P&G has increased its dividends in each of the past five years, in tandem with its earnings growth. Such dividend staying power is what you hope to see in a slow grower. P&G has also been buying back its own stock, about 1% of it each year since 1996, which is another way to return money to owners.

What's the Return on Capital?

In addition to returning money directly to shareholders through dividends or buybacks, a good company should earn a high return on its shareholders' money. On the surface, Procter & Gamble has done very well. The company's return on equity (ROE) has grown to the mid-30% range, putting it in the top 10% of its industry as of the end of 1999. Those are attractive numbers, but there are some warning signs to watch out for. P&G's improved ROEs in 1998 and 1999 were the result of increased debt, as its financial leverage rose from 2.7 to 3.1. The company's return on assets (ROA) actually declined in 1998, and it continued to fall into 1999. Procter & Gamble remains much more profitable than most companies in the consumer-products industry, but the two trends--lower ROAs and more debt-reliant ROEs--need to be halted. For a company that doesn't dazzle with its growth, high returns on capital are one of the key attractions.

How Has the Stock Performed?

Procter & Gamble's steady performance and high profitability translated into impressive returns during the 1990s. P&G's stock returned more than 30% on an annualized basis from 1994 through 1999, beating the S&P 500 in three of those years. Moreover, these returns were steady over time, without the wild swings that characterize many stocks in hot sectors such as technology. However, early 2000 was a different story. A failed attempt to take over two major drug companies, followed by a warning of lower profits, sliced 40% off P&G's stock price during the first three months of the year.

Is the Stock Priced Like a Slow Grower?

For a slow-growth company to make an attractive investment, it had better be priced like a slow grower. Paying a high multiple for the earnings of a historically slow-growing company is basically a bet that the future will turn out better than the past--always a risky wager to make, especially with this type of stock. Procter & Gamble's valuations were somewhat high at the end of 1999--higher than those of the S&P 500. That premium was justified, given the company's remarkably steady performance up to that time. However, the plunge in P&G's stock price in early 2000 brought its valuations in line with those of the broader market--justifiably so, given the market's lower expectations for the company.

Conclusion: What Do I Get in Return?

If they compensate for their slow growth by demonstrating other attractions (such as high returns on capital), and if they trade at a reasonable price, slow-growth firms can make sound investments. Procter & Gamble boasts a number of attractions: It generates heaps of cash, it earns higher than average returns on its capital, and its stock has been a very reliable performer. Digging deeper into its numbers reveals some potential causes for concern, though nothing to panic about. Procter & Gamble's earnings growth has been steadily slowing, and its returns on capital, while excellent, have shown signs of strain. Most important, Procter & Gamble is cheaper than it was in 1999--and that's a plus for a slow grower.

Quiz 406
There is only one correct answer to each question.

1 Slow-growth companies are typically:
a. Less profitable than fast growers.
b. More profitable than fast growers.
c. It depends entirely on the company.
2 What does it mean to say that a company is a money pit?
a. It is sucking up more money than the business is generating.
b. It is an island of value among expensive stocks.
c. It attracts a lot of money from investors.
3 Why might a slow-growing company choose to pay dividends to shareholders?
a. In order to boost share price.
b. The company generates more cash than it can use for profitable growth.
c. In order to boost its return on equity.
4 Which of the following is <em>not</em> a warning sign for a slow-growth company?
a. Rising net margin.
b. Rising financial leverage.
c. Falling returns on assets.
5 Which of the following is <em>not</em> an area in which slow-growth companies often excel?
a. Growth prospects.
b. Dependability.
c. Profitability.
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