The Growth Investor
Seeking capital gains with this popular investing style
Growth investing is a popular investing strategy which seeks out stocks that have been reporting a rapid growth in their revenue and earnings over the last three to five years. This proven track record of growth provides confidence that the company has the ability to continue to grow into the future.
These historical growth rates are used in conjunction with the stock's future revenue and profit forecasts obtained from analyst's estimates in order to determine the company's future growth potential. This is an important aspect of growth investing, as growth stocks typically command high PEs. The stock price paid for its current earnings is high as investors are actually paying for the stock's future earnings.
Example: EPAM Systems, Inc. NASDAQ:EPAM has 2016 earnings of $1.94 with forecast earnings of $3.40 for 2017 and $4.10 for 2018. The current stock price is $77.80 (Apr 25, 2017).
The PE ratio is 40 based on the last fiscal year (which is quite high), however EPAMs current 2017 PE is down to 23 and its 2018 PE is down to 19.
Growth investors generally pay premium prices for these high growth stocks, which can lead to PE ratios (Speculative stocks can have PE ratios of 100 or more). This is based on the notion that these high growth stocks deserve higher than average PEs because of their enormous growth potential and hence its future stock price appreciation.
Rationalizing the reasoning behind this is quite easy.
Example: Skyworks Solutions, Inc. NASDAQ:SWKS has a PE ratio of 20 based on last fiscal years 2016 earnings of $5.39 and has increased its earnings by 30% a year over the last five years.
At this growth rate, in three years its earnings would be $11.80 and in five years its earnings would be $20.00.
So with a current stock price of $104.26 (Apr 25, 2017) its current PE ratio is 20 (which may seem a little expensive now), however in five years time its stock price could be around $400 with a PE ratio of 20.
Thus it is not difficult to see why stock investors are attracted to high growth stocks.
While high growth stocks can provide significant capital gains, their stock price is also vulnerable to investors' willingness to continue to pay these high PE ratios, as they are paying for the company's future value today which may not materialize in the future.
With great rewards comes great risk and this risk needs to be managed. The growth investor's biggest enemy is the Bear Market which can totally destroy the value of their portfolio.
With high growth stocks, the stock price tends to grow faster than the company's valuation, and this leads to a couple of issues. Those stocks that do not meet analysts forecast estimates when reporting time comes, can have their stock prices reduced dramatically by investors selling out as they perceive that the company's future growth prospects are over. Simply having a notable analyst lowering their forecast estimates can lead to a similar stock price decline. Also a stock which fails to exceed its whisper number can sold down heavily. The same can easily occur if the industry group the company belongs to or the economy in general show signs of growth slowing.
The stock prices of growth stocks are typically volatile and sensitive. Stock investors who invest in these volatile stocks need a relatively high degree of patience and to be able to psychologically handle the dramatic stock price fluctuations that accompanies this style of investing.
Characteristics of High Growth Stocks
Growth investors seek out growth stocks by analyzing the fundamental information available to them. The characteristics of high growth stocks that growth investors look for include the following.
Characteristics of high growth stocks
- High one-year, three-year and five-year historical revenue and earnings growth, which has been growing at a significantly faster rate than the economy and the industry average.
- High forecast earnings for the next couple of years that are at least as strong as the stock's historical growth rate.
- High quarter to quarter earnings growth rates provides evidence that the stock's growth is more consistent and continuous throughout the year.
- Expanding profit margins are desirable as this indicates that the company can produce a higher proportion of profit from its revenue.
- Are in an industry that is growing or the company has a new or improved technology, product or service.
- Tend to be smaller companies which generally find it easier to expand than large established companies. A smaller company with a new product and an aggressive marketing campaign could potentially double its profit but a large blue-chip will find this extremely difficult to achieve.
- Insiders such as directors and key employees may be purchasing stock. These insiders know the company and their own buying provides some additional confidence that the company has further potential to grow.
- Stocks with a history of reporting earnings that exceed analysts estimates on a regular basis, are demonstrating their ability to grow.
- Analyst estimate downgrades are not desirable as there is now some doubt as to the stock's future growth prospects.
- Stock prices are generally in an uptrend which provides a lot of confidence to investors that this trend will continue.
Not all good growth stocks will necessarily display all of the above characteristics, however the more characteristics a stock has then the chances of its future success is increased. Certainly all growth stocks must be fundamentally sound and have a solid history of earnings growth to even be considered a growth stock. Conducting a through fundamental analysis will increase the likelihood of success and it is also prudent to check the company's Z-score for its bankruptcy risk.
Growth investing involves tracking each quarterly earnings report to determine whether the stock still has sufficient future growth potential and if not, then the stock is sold and another growth candidate is selected in lieu. Growth investing is generally not suited for the buy and hold investor due to the high risks of the stock's price collapsing.
Growth stocks should be fundamentally sound
and have a solid history of earnings growth
To mitigate the high risk involved in growth investing, most professional stock investors who hold growth stocks have an exit planed in the event something dramatic happens that would cause the stock's price to decline significantly. Their exit strategies range from exiting when a reduction in earnings or revenue growth is experienced, through to using price stop levels where the stock is sold when the stock's price drops by a certain percentage.
Once a growth stock portfolio is setup it does not require a lot of ongoing portfolio management, since by the very nature of investing in the company's future growth, which takes years to evolve and as such growth investing is generally a medium-term to long-term investing strategy.
To summarize, growth investing during buoyant economic times can be extremely profitable, which certainly contributes to this strategies popularity. However caution needs to be exercised when any factor that would reduce or halt the growth of these companies emerges, which can make this strategy quite risky if the stock is not sold as the ensuing price declines can be dramatic. Some of the spectacular price declines in history have seen stocks lose 90% and more from their peak. Growth investing is only suited to bull markets and some investors make use Dow Theory to determine whether market conditions are favorable or not.
Growth Stocks that Stop Growing
When it's time to get out
When a growth stock stops growing, it is no longer considered a growth stock. This may seam obvious, but the reality is that it is considerably more difficult to precisely pin point when this actually occurred.
The barometer that measures growth is the continuing increase in revenue and earnings. Any slowdown in revenue and earnings growth is undesirable as this may indicate to investors that the good times are over and thus these investors sell down their stockholdings, which has the consequence of driving down the stock's price.
So just exactly what does a slowdown in growth mean?
The earnings growth rate is commonly calculated from a stock's historical earnings. A common calculation is to use the last fiscal year's earnings and the earnings from 5 years ago to calculate a compounding growth rate using the following formula.
Growth Rate = ((Earnings1/Earnings5) ^ (1/5yrs) - 1) x 100%
Let's use Martin Marietta Materials, Inc. NYSE:MLM as an example of a stock that has been increasing its earnings over the last five years.
Table 1. MLM - Revenue and earnings growth
The earnings from 2016 is $6.74 and the earnings from 2012 is $1.84. The 5-year growth rate is 30% per year and is calculated as follows.
Growth Rate = (($6.74/$1.84) ^ (1/5yrs) - 1) x 100% = 30% per year
While the growth rate applies to both revenue and earnings, it is common practice amongst stock investors to only use the growth rate figure that refers to the earnings growth rate. However, it is better to also use a separate figure for the revenue growth rate as well, which gives a more complete picture of the stock's growth potential.
As a hypothetical example only: Let's suppose that Martin Marietta Materials reported its 2017 earnings of say $4.31 (which is the same as the 2015 earnings), the earnings growth would now only be 15% calculated as follows.
Growth Rate = (($4.31/$1.84) ^ (1/6yrs) - 1) x 100% = 15% per year
Thus the earnings growth would have 'slowed' to 15% which is only halve of the 30% the earnings had been growing at. At first glance the stock investor may think that this still quite respectable, however here lies the problem and indeed the risk to the stock's price.
Many stock investors will justify the stock's PE ratio based on its earnings growth rate. For the Martin Marietta Materials example the earnings were growing at 30% per year, a fair value would have been a PE ratio of 30.
However, should the earnings growth reduce to only 15%, stock investors may very well revalue this stock to a PE of 15. This is especially the case if analysts are forecasting lower grow rates or if there are any signs that the industry may be heading towards more difficult times.
In the case of Martin Marietta Materials there is no earnings forecast data available.
Growth investing also uses forecast revenue and earnings growth data were available, however when growth investors feel nervous they can totally ignore this (even if the forecasts are good) and liquidate their positions in a panic driven frenzy. The fear is that this stock may now only grow at a much slower rate which would only justify a lower PE ratio.
This now causes a major problem for a stock whose PE ratio is halved. The stock's price will now need to approximately halve in order to give the same PE ratio.
This is illustrated below for Martin Marietta Materials with a stock price of $224.04 (based on Apr 25, 2017). If the growth rate did halve, the PE ratio may well halve in order for investors to justify the slowed earnings growth rate.
2016 old PE ratio = 224.04 / 6.74 = 34
The new PE ratio would be 17 if halved which gives a stock price of $73.27
2017 new PE ratio = 73.27 / 4.31 = 17
The stock price needs to fall to $73.27 to give a PE ratio of 17 should the 2017 earnings come in at $4.31. Thus the stock price could fall by more than half.
Note: While this is only a hypothectival example as the 2017 fiscal year has not yet completed, it does illustrate what could happen if Martin Marietta Materials 2017 earnings did disappoint.
As a general rule, the more overvalued the stock is, the more likely that the stock price correction will be severe. This is especially true if there is any sign that the stock's future earnings growth rate might be threatened.
This causes a major problem for the
stock whose PE ratio has halved
A growth stock is considered fairly valued if the PE ratio equals the annual earnings growth rate. The growth stock is considered overvalued if the PE ratio is higher than the earnings growth rate, and considered undervalued if the PE ratio is lower than the annual growth rate.
This still leaves the unanswered question of whether the above mentioned stock that was growing at 30% per year is now still considered a growth stock. A lot of stock investors will base the answer to this based solely on the stock's price performance. If the stock's price halved, they will say it is no longer a growth stock, however if stock's price did not significantly alter, then they will say that it's still a growth stock that may well report a strong earnings increase in 2018.
For this example, the stock is still growing its earnings and thus still makes it a growth stock. It is just that the 2017 growth rate was not as good as prior years. Most growth stocks will have a range of earnings growth rates that will fluctuate from year to year. The important consideration here is that the earnings trend continues upwards.
Now what if a company reports a significant drop in earnings or even an earnings loss. By definition this stock is no longer increasing its earnings and thus is no longer a growth stock. This does not mean it is a bad company or that there are any major financial issues. Most companies will report a bad earnings result every so often, which will typically see their stock prices being hammered down. The main thing here is that the stock is still fundamentally sound so that it can re-continue to grow its earnings after this set back.
The question all stock investors will ask here is whether they should sell their stock if the earnings growth rate drops to say halve. This is the difficulty in using fundamental analysis in order to determine when to sell a stock holding. On the one hand, if the investor sells their stock and the stock then reports a 30% increase in earnings the following year, the investor will no doubly be disappointed that they sold out when they did. Conversely, if the stock investor does not sell and the following years earnings growth drops significantly, then one can be certain that the stock's price is really going to tumble, leaving the investor wishing that they had sold before things got really bad.
A trick that professional stock investors use is to sell on strength and re-buy on weakness. So for the growth example, if the stock's price did not decline by any significant amount, the stock investor may feel comfortable in still holding this stock as there is a good chance that the earnings will pick up the following year (assuming that a fundamental analysis confirms this). However, if the stock's price starts to decline more significantly, then the stock investor may feel more comfortable in selling the stock. If the earnings growth rebounds next year thus reaffirming that its still a growth stock, the stock can always be repurchased.
This process of incorporating price behavior into the investing decision making process is known as technical analysis. Most professional stock investors incorporate at least the basic principles of technical analysis into their fundamental decision making process in order to manage and control the risks associated with growth investing strategies.
Finding Good Growth Stocks
How to find good growth stocks for your portfolio - to maximize your returns
Constructing a suitable portfolio is the second step in being a successful growth investor. The first step is to thoroughly understand the benefits and risks associated with growth investing, and that the aspiring stock investor has the required psychological mindset to handle this aggressive style of investing.
The ongoing maintenance for a growth portfolio is fairly minimal, with most of the effort needed being in setting up the portfolio. Once setup, the portfolio does not require day to day attention.
It is prudent for the growth investor to diversify their portfolio across varies industry groups rather than concentrating on one or two industries. Also, holding a higher number of stocks with smaller share quantities reduces the impact on the portfolio if any one stock performs disastrously. Risk management is extremely important with growth investing.
Generally holding 10 to 20 stocks provides a good balance between reducing risk and the time needed to set up the portfolio. Holding more than 20 stocks marginally reduces the risk further, but this now increases the effort needed to set the portfolio and also starts to require more time to monitor the portfolio.
Finding Good Growth Stocks
One method of finding good growth stock candidates is to use the intuitive approach that the famous investor - Peter Lynch uses (who is probably one of the world's greatest stock investors). His approach is to study the environment that people live in and observe the products and services that people use and need. Then he finds a new and upcoming company with a thriving management team that can fulfill this demand.
While the intuitive approach has its merits, most stock investors would be more comfortable with a quantitative approach, for the simple reason that it's easier to implement.
Online stock brokers generally have some type of fundamental screening application that growth investors can use to obtain a list of potential growth stock candidates.
- The first step is to run a screen to filter and sort the stocks with the highest three to five year historical EPS growth rates and revenue growth rates. The growth rate value used is a little arbitrary, but a figure of 15% or more is typically used. The higher the figure that's used, then the smaller the list will be.
- The next step is to filter this list for those stocks that have forecast EPS growth rates that are equal to or greater than the historical growth rates. Depending on the current economic environment, this list may quite large or quite small.
- Market capitalization now needs to be carefully considered. Basically, the smaller the company, the higher the risk will be and the greater the profit will be. What range of market-cap values to accept is dependant on each individual investor's personal circumstances?
Selecting which Stocks to buy
By now, the list only contains those stocks that have been growing significantly and are expected to continue to do so. These are the most important criteria for a good growth stock.
The following are more minor but serve to increase the likelihood of the growth stock succeeding.
Selecting the Stocks:
- Stocks with steady or expanding profit margins are desirable as this indicates that management is able to extract an increasing portion of profit from its revenue.
- Stocks with more consistent quarter over quarter EPS growth rates are desirable.
- Any analysts estimate upgrades or any recent earnings that exceeded analysts forecasts are desirable.
- Any insider buying or at least no insider selling is desirable.
- Buy recommendations by analysts are desirable, but sell recommendations are undesirable.
Once the final list is completed, then the stock investor needs to determine which stocks to select from this list. To a certain extent this depends on how many stocks are in this list.
Generally it’s better for the stock investor to be
choosy and only include the best candidates
For the stocks that meet the above criteria, then the stocks with the lower PE ratios would probably be the wiser choice as there is less downside risk and more upside potential for the stock's price to appreciate.
It is a bonus if the stock investor is intimately familiar with the industry that a particular candidate belongs too, thus allowing the stock investor to utilize some of the intuitive approach that Peter Lynch is famous for. For example, an investor may be familiar with the drugs industry and may readily recognize that a company on the list is actively developing a new pill that will rapidly relief headache pain in under 60 seconds. Needless to say that there certainly is a large market for this product and as such could well propel this company's earnings and hence stock price upwards.
It is generally better for the stock investor to be choosy and only include the best candidates in their portfolio and exclude the marginal candidates. Hastily filling a portfolio with marginal candidates only increases the risk. The portfolio can be built up over time by more carefully selecting only the best stocks.