For many investors, the task of scouring the market for companies that look poised for rapid growth is the holy grail of stock selection. The stocks chosen by growth investors boast an air of anticipation as finding a long term winner can transform the value of the smart investor’s portfolio. But how do you capture a potential ‘tenbagger’ before it gets away from you?
Growth investing has inspired acres of research and writing and elevated a handful of successful investors to near-celebrity status for their screening strategies. Dig deep and you’ll find there are some common themes that lie at the heart of growth stock selection. We highlight the top 4 common themes here.
1. Fast and Persistent Earnings Growth
Studying a company’s historic and projected profitability is a central plank in every growth investing strategy because without earnings it is near impossible to assess or benchmark the growth potential of a stock.
Back in the 1930s, US asset manager T. Rowe Price (known as the father of growth investing) put earnings front and centre of his buying strategy and stipulated long term earnings per share (EPS) growth as a buying requirement, together with forecasts that EPS will continue to grow ahead of inflation. More recently, US investors William O’Neill and Martin Zweig have been among those to adopt the same tactic.
According to O’Neill – whose CANSLIM investing technique and now legendary book “How to Make Money in Stocks” earned wide acclaim in investing circles –winning stocks generally have strong quarterly earnings per share performance prior to their most spectacular price run ups, as well as a history of steady and significant annual earnings. He puts a particular emphasis on the importance of sales growth in his screen and stipulates that sales should be rising by at least 25% year-on-year (or at least accelerating over the last three periods). Considering that O’Neill studied the history of 40 years of the greatest stock market winners these findings are worth noting.
Zweig’s strategy is even more demanding and calls for stocks to pass numerous earnings related criteria. Among them, EPS growth and sales growth should each have grown by at least 20% over the previous four years. And to insulate against more recent wobbles, the EPS should have been accelerating in the most recent quarters.
2. Buy Growth on the Cheap with the PEG Ratio
Unlike value chasers, who put substantial emphasis on filters such as the price-to-earnings ratio when it comes to assessing the best time to buy a stock, growth investors are divided on the importance of PE.
Screens developed by the likes of Price and Zweig take a strong interest in buying stocks at moderate PEs, which has earned those strategies the moniker “growth at a reasonable price”. By contrast, Philip Fisher, another celebrated US investor, is more sceptical. While Fisher, like his peers, looked for well priced stocks, he was equally comfortable to hold them for the long term, even if they became overvalued.
A more practical way of using PE in a growth strategy is to adopt a tool developed by UK investment guru Jim Slater known as the price-earnings growth factor, or the PEG.
The PEG is Slater’s ultimate metric, which scrutinises the relationship between a stock’s expected PE ratio and its expected rate of EPS growth. The approach leans heavily on the forecasts of analysts, which have a chequered record in predicting the future, but it has still won many admirers.
A PEG of less than 1 indicates that a company is growing EPS faster than its PE Ratio, and is a good rule of thumb for finding a cheap growth stock.
3. Something New – New Technologies, Management or Products
By far the most memorable advice from ex-Fidelity fund manager Peter Lynch is for investors to keep their eyes open on main street for new products and trends. His assertion that a private investor can outperform institutions by keeping an eye on what his wife is buying in the local shop, carries serious resonance with the lay investor. Companies that you come into contact with in your day-to-day life can be worth a much closer look – how many of us failed to buy Apple when the iPod was so obviously a success?
Finding a stock with something new or some technological edge or innovation is a recurring theme in growth investing, and Philip Fisher was one or the early proponents. His analysis, although driven by fundamentals, placed substantial emphasis on quality management with a determination to continue developing products or processes. Famously, Fisher bought shares in Motorola in 1955 and held the stock until his death in 2004. In that time the shares grew 20-fold.
Similarly Bill O’Neil discovered that new services and innovation were such an important factor in the price performance of market winners that he made this qualitative fact a key part of his CANSLIM system.
4. Increasing Share Price Momentum
The performance of a company’s shares compared to the wider market is a key factor for growth investors as no stock can ‘tenbag’ without consistently breaking out to new highs. Jim Slater is a fan of strong share price outperformance (or relative strength) because he says it shows that investors are beginning to appreciate a company’s potential. His strategy insists that a company’s shares should display high relative strength in the last one (or three) months and the previous 12 months compared with the market, with the 12-months being higher than the one-month. Martin Zweig used a similar benchmark in his strategy, rejecting companies that were underperforming the market, particularly when the market was performing well.
Taking the relative strength theme even further, Bill O’Neill suggests buying “the leading stock in a leading industry” and used relative strength to identify this. Specifically, he compared a stock’s 52-week relative strength rank against a basket of stocks that had performed better than 80% of all stocks in the FTSE All-Share. In addition, he preferred to invest during times of definite uptrends – where the index is trading above its rising 50-day and 50-week moving average.
For investors pondering growth as a driver for their investment strategies, there is no shortage of inspiration from the screens developed by some of the market’s most influential investors. Within those screens, Earnings, the PEG, Innovation and Price Momentum are recurring themes that offer a useful starting point in scrutinising potential investment candidates. Using Stockopedia PRO you can access all of the screens developed by Fisher, Lynch, O’Neill, Price Slater and Zweig to see the growth stocks that are currently matching their criteria.
Filed Under: Growth Investing,