Don’t waste your time on interest rate speculation and find listed companies with strong growth

Investors are all at sea over the future course of interest rates but you should look closer at stock performance if you want the best rewards.

The time is right for small caps such as four wheel drive accessories group ARB

Many years ago, the dean of Wall Street, Ben Graham, criticised the preponderance of speculation he observed in the stock market, noting, “We have reached the third degree where we devote our intelligence to anticipating what average opinion expects the average opinion to be”.

As debate rages and guesswork abounds about whether the Reserve Bank of Australia and the US Federal Reserve will cut interest rates, I am reminded of Ben Graham’s reference to its futility.

Of course, there are visible reactions in share prices to the emergence of optimism or disappointment. When equity participants have loaded up on equities amid expectations rates will be cut three times this year, and they aren’t, it is reasonable to expect they will temper their hitherto enthusiasm by rebalancing, reweighting, repositioning or reshaping their portfolios based on the “new” news.

Instead of trying to get central bank rate forecasts correct, we would be better served understanding what is most important – isolating those businesses with the longest runways for double-digit earnings growth.

What we should be doing is simply stated but far more challenging in practice and that’s teasing out from a sea of businesses those that can sustain strong earnings growth.

Amid the forces of capitalism, which include supply, demand, competition, changing consumer preferences, emerging superior technologies and others, the investor is charged with the responsibility of picking a group of companies which will grow for at least a few years and, ideally at double-digit rates.

Costume jewellery retailer Lovisa is worth a look.

In Australia, there are many businesses which have a strong, but by no means certain, ability to grow earnings at attractive or even very attractive rates, including small caps such as Lovisa, ARB, Tuas, Macquarie Technology and Megaport.

Overseas, there’s a plethora of companies which are growing at double-digit rates, including big household names like Adobe, Microsoft, Alphabet and Amazon. Lesser-known names also growing include SAP, Autodesk and Workday.

The point is that many of these businesses will grow regardless of whether the Fed cuts rates once, twice, three times, or not at all. Sure, the share price might react to a reappraisal of the rate-cutting outlook, but such share price moves tend to be temporary, and they ultimately return to following a company’s earnings path.

Why so much focus on growth? It’s because earnings growth forms part of a very important framework for thinking about how and when to invest in shares.

Assuming there is no change in the price-to-earnings (PE) ratio when you buy and sell shares in a company, which means there is no change in the popularity of stocks, your return will equal the earnings per share (EPS) growth rate. In other words, if the PE stays the same and if the company’s EPS grows at 20 per cent per year, so will your shares increase by 20 per cent per year, and therefore that becomes your annual compounded rate of return.

If I buy a share of a company on a PE of 10, 12, 15 or 20 times its EPS and it grows its EPS for the next few years at 20 per cent per annum, and I then sell the shares on the same PE ratio that I paid for them, I will earn a 20 per cent return on average every year.

That’s a big reason to demand your share portfolio (or that of the fund manager you decide to invest with) be filled to the brim with companies growing their earnings at strong rates.

And what if the stock market’s popularity falls over the period you own the shares and the PE contracts?

That fear is enough for many investors to avoid investing in stocks altogether. If a company with the same 20 per cent EPS growth rate as before is selected, but over a five-year investment period, the PE contracts by 25 per cent, the investor will receive a 13 per cent per annum return. Still attractive.

And let’s not forget the stock market could become even more popular over the next few years. This would be reflected in an even higher PE ratio and my return would be better than 20 per cent per annum for our hypothetical example.

If a company can do this, and you collect such companies for your portfolio, your returns will be attractive regardless of whether the RBA or the Fed cuts rates, raises them, or sits pat.

And in any case, as my own research in the 1990s revealed, the markets are rubbish at forecasting rates. You won’t need to worry about forecasting anything if you can build a portfolio of companies whose earnings march upwards

Roger Montgomery is founder and chief investment officer at Montgomery Investment Management