What an amoeba can teach us on investing

Single-celled organism holds many lessons for investing wisely

I wonder how many of you are familiar with the "Amoeba Theory of Investing".

I'll hazard a guess and say that not many are because it is an idea that I came up with while playing around with numbers on my calculator.

It is not a concept that I have shared widely either, because it is still in its developmental stages. That notwithstanding, here it is. But before that, here is a very quick quiz that I hope will help set the scene.

If an amoeba in a jar doubled every second and it took precisely one minute for the amoebas to fill the jar, how long would it take for the jar to be exactly half full?

Just like the amoeba in the jar, growth can come to an end, sometimes very abruptly. The secret to growth investing is, therefore, simple. Look for companies whose fast-growing earnings will translate into higher share prices.

Some of you might point out that I haven't given you nearly enough information to solve the puzzle. After all, does it not depend on the size of the jar and the size of the amoeba?

But all the information that you need to arrive at the correct answer is already embedded in the question.

The answer is 59 seconds. Why? It is because precisely one second after that (that is, at the 60th second), the jar will be completely full. But what does this have to do with investing? In my view, it has a couple of important things that could help us become better investors.

First, much of the information that we need to make good investing decisions is readily available.

They can be found in a company's balance sheet, its profit loss accounts and the cash flow statement.

They can also be found in research reports about the particular industry that a company operates in.

Quite often, the information is available for free. Making use of the information properly is crucial to making the right decisions about the companies we invest in.

Warren Buffett once said: "The key is having more information than the other guy - then analysing it right and using it rationally."?

The second takeaway from the "amoeba"? analogy concerns growth investing. Growth investors are often on the lookout for companies that can expand faster than the wider market.

Growth shares were very popular in the 1990s, when technology companies were all the rage and many growth investors were making money hand-over-fist - often effortlessly.

Embryonic technology companies would, for instance, see the popularity of their product or service double very quickly from a standing start.

The valuations of these businesses would also rise, often in tandem, if not faster. Consequently, many investors armed with just a pin and a list of fast-growing companies could almost pick growth shares blindfolded.

Unfortunately, many also came unstuck, when growth came to an abrupt halt.

But how do you find good growth companies? One way is to look for companies that have demonstrated rapid growth in the past. The idea here is that if a company has been able to show growth quickly in the past, say, over the last five years or so, then it could grow for the next five years, too.

What we are looking out for are companies that have proven track records in handling growth. It is also vital to look for companies whose profits are growing at a reasonable clip.

Characteristically, these tend to be younger companies. But we should not dismiss older outfits out of hand.

There may be life in the old dog, yet. After all, if a company has successfully grown profits at 20 per cent a year, and is forecast to continue to grow at 20 per cent a year, then it means that profits could double in around five years.

Look for companies with sustainable margins, too. It can be an indication that the managers of the business are able to keep costs under control.

Ideally, we want to see operating margins strengthen as sales rise. It can be a good indication that the business is scalable. In other words, it can grow sales without having to increase costs disproportionately.

Finally, we circle back to the humble amoeba. It may seem obvious, but it is crucial to identify market limitations.

Fast-growing businesses rely on markets that can grow quickly enough to adopt and buy the company's goods or services.

However, bear in mind that markets have limits beyond which growth companies will find it difficult to expand.

So, just like the amoeba in the jar, growth can come to an end, sometimes very abruptly.

The secret to growth investing is, therefore, simple.

Look for companies whose fast-growing earnings will translate into higher share prices.

Generally, growth companies can be more expensive than the market average.

But this is in the hope that the value of the business will grow and exceed current valuations.

The tough part is to know when growth is about to end, and to get out before it does.

• This is a regular monthly column on stocks and investing by Mr David Kuo, chief executive officer of The Motley Fool Singapore.

A version of this article appeared in the print edition of The Straits Times on December 07, 2015, with the headline 'What an amoeba can teach us on investing'. Print Edition | Subscribe