A 1930s growth stock strategy that still works in volatile markets

The work of Thomas Rowe Price Jr still applies today, and is even better than more modern strategies, Ben Hobson argues.

In just over a decade since the financial crisis, growth strategies have proved to be some of the best ways of profiting from the stock market. But this year, economic strife has put “growth” under huge strain. Investors no longer enjoy a plentiful supply of shares offering fast-paced earnings - but they can still be found if you know where to look.

Back in 1937, a man named Thomas Rowe Price Jr opened a small investment business in Baltimore, US. His timing was hardly ideal, given that the Great Depression was only just ebbing away and the Second World War beckoned. Even so, T. Rowe Price went on to thrive, and today it is one of the biggest asset managers in the world, with more than $1 trillion (£770 billion) under management.

What set Rowe Price apart was an investment approach that focused on growth. Unlike the highly speculative strategies that had caused so much damage in the Wall Street crash of 1929, he was mindful of the business cycle.

In fact, he ditched the conventional wisdom that all stocks were cyclical. Instead, he believed that most companies passed through a life cycle of growth through to maturity and then decline. So he advised looking for “fertile fields for growth” and then holding those stocks for a long time.

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In detail, his strategy had both qualitative and quantitative rules. He liked to see aggressive, efficient management and well-paid employees. He also liked innovation, with firms that were making new products for new markets or doing something different in a mature market. It was there that he saw the potential for high profits.

In terms of financial measures, Rowe Price set out a number of rules that you see in a number of growth strategies today. He wanted to see strong and improving earnings, positive cashflow, a solid return on invested capital and high margins. But crucially, he did not want to over-pay. His was a “growth at a reasonable price” strategy and so the price/earnings ratios of his stocks needed to be restrained.

Rowe Price passed away in 1983 but by then he’d earned a reputation as the “father of growth investing”.

A strategy for the modern day?

A major problem for growth strategies this year is that there just are so few stocks that qualify for them. On one hand, earnings forecasts have been pared back right across the market, and that naturally affects these approaches.

But equally, small-cap growth names have actually performed quite well in 2020. And with rising valuations, growth strategies that insist on reasonable price-to-earnings (PE) ratios have suddenly found that there are fewer options out there.

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But the T. Rowe Price strategy offers some hope. Stocks that are trading on below average PE ratios, with above average earnings per share (EPS) growth over one, three and five years, positive cashflow, and high margins can be found.

Here are some that currently pass those tests. They range from financial trading firms like Plus 500 (LSE:PLUS), CMC Markets (LSE:CMCX) and IG Group (LSE:IGG) to innovative companies like Somero Enterprises (LSE:SOM), Hikma (LSE:HIK), Auto Trader (LSE:AUTO) and Judges Scientific (LSE:JDG).

Buying growth on the cheap is a tried and trusted strategy among some very successful investors. It naturally comes with risks (so it is important to be careful, especially in unpredictable conditions) but it can point to some potentially exciting companies.

Thomas Rowe Price Jr’s strategy combined growth and valuation with a consideration of the business lifecycle and a focus on companies with new products and new markets. It helped to forge what is now one of the most successful fund management companies in the world - so it is an approach that might be worth a closer look.

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