Earnings Growth: The Golden Touch

Your job as an investor is to preserve and increase your net worth. Your enemies are spending, taxes and inflation. Spending can be controlled. Taxes may be deferred, sheltered and avoided but not evaded. Inflation cannot be deferred or evaded but it can be overcome. One of the surest ways of defeating these enemies is to have a portfolio of solid growth stocks.

SETTING INVESTMENT OBJECTIVES. The rate of return needed to cope with taxes, overcome inflation and provide current income varies with economic conditions and your personal circumstances. Only you can decide how much cash you need for spending. Beyond the need for current income, the minimum rate of return you should aim to achieve is equal to the sum of the CPI inflation rate plus the yield on long term AAA corporate bonds. In the early 1980's, this sum was about 20 percent per year. With inflation currently at three percent and AAA corporate bonds yielding about seven percent, it is now about 10 percent per year.



Stocks have appreciated historically at an average rate of nine percent per year. The average earnings growth rate for American companies also has been about nine percent per year. This is not a coincidence. Earnings growth is the engine that drives stock prices higher and higher.

The earnings growth rate of your stocks must be consistent with your investment objectives. If you want to double your money every five years, you should have a portfolio of solid stocks growing at least 14 percent per year. When inflation and interest rates increase, it's necessary to adjust your investment objectives accordingly. A thorough understanding of the role of earnings growth, how growth rates are estimated and the appropriate use of growth estimates will help you select the right stocks.

THE ROLE OF EARNINGS GROWTH. Companies must grow to stay alive. They cannot stand still. Spending, taxes and inflation erode a company's wealth just as they do yours. If a company fails to grow fast enough to stay ahead of these common enemies, it will eventually die. On the other hand, a company will prosper if its earnings grow steadily at a robust rate. Earnings growth is a manifestation of a company's health and future prospects. It is also a key indicator of your portfolio's health and potential. Read more