Screening For Growth

May.27, 2007 in Market Outlook

Growth Investing

Investing for growth is one of the mainstay styles for longterm investors. It is mainly geared toward people who have financial goals that are at least five years away. This investment style involves looking for companies whose sales and earnings are growing faster than the market, with the goal of finding the rising stars. It looks for firms that have both top and bottom-line growth, ideally at a consistent or predictive rate. You should know that instead of paying large dividends to their shareholders, growth companies try to use their assets and to reinvest the profits to make their businesses expand and, over time, offer substantial capital appreciation to their shareholders. Growth companies are usually aggressive in pursuing profitable ventures and retain a substantial portion of their earnings for research and development.

In bull markets, growth stocks generally outperform value stocks. Growth stocks are highly weighted in certain sectors because certain industries tend to grow much faster than the overall economy. In recent years, most information technology and biotechnology stocks were classified as growth. Very few utility and real estate investment trusts would have been classified as such. Some current examples of growth stocks are Qualcomm (QCOM), eBay(EBAY), and Amgen(AMGEN). Investors should be cognizant that over time, the sectors heavily weighted in the growth and value styles change. In another era, for example, steel and railroad companies were considered the growth stocks.

Growth Ratios

Note the main ratios that money managers have historically looked at in considering whether a stock is a growth stock:

Forward and historical Price/Earnings ratio
Price/Sales ratio
Price/Book ratio
Price/Cash flow ratio

For each of these ratios, a growth stock should have valuations above the market. In general, investors are willing to pay for reliable growth. A growth stock should also have sales and earnings growth that are clearly outpacing the market’s average. An investor should try to determine if the growth is sustainable and avoid issues that have achieved growth by one-time, extraordinary, or short-lived methods.

Growth Curves

In general, companies stay in the growth category for a shorter amount of time than the value category. All things being equal, if you ran both growth and value screens periodically, the growth screens will tend to have more turnover. For businesses, the rapid growth phase is a much shorter period of time than the mature and decline phase.

Unfortunately, trees do not grow to the sky, just as growth does not last forever. There is a limit to the amount a company can increase sales and earnings. Expansion plans have their limits. Patents and copyrights eventually expire. Product life cycles are short.

And then there’s competition. If a company has tremendous earnings and sales gains, competition is likely to follow. It may be from established domestic, international, and/or start-up firms, or in a lot of cases it may come from unforeseeable places. For example, 10 years ago telephone companies didn’t view cable companies as potential threats.

Another brake on growth is that employees responsible for growth of the corporation may be harder to retain. And finally, there’s always the threat of government regulation. Through antitrust legislation and sanctions, the government tries to eliminate monopolies and dissuade anticompetitive activity.

For the investor, growth stocks do come with some risk. Due to their higher valuations, lower dividend yields, and high betas, they tend to be more volatile and decline more in bear markets than non-growth issues. Investors should thus be attuned to when a growth company is scheduled to released its earnings numbers. The day of the earning release is usually a volatile one for a growth stock. They are often priced for perfection for their earnings release. When growth stocks miss their earnings estimates, they can be subject to harsh declines in value. Often, even when they meet their earnings numbers, they decline, because investors have such high expectations for them. They want favorable earnings surprises.

But any type of negative news can cause a sharp drop in a growth stock’s price. Beside being priced for perfection, with little room for mistakes, in many cases the companies themselves are euqally subject to rapidly changing technologies and developments. This can lead to quick success in the marketplace but also to obsolescence if the growth company is not careful. Eight-track tapes, walky-talkies, and slide rules are examples of products that were once considered innovative that became obsolete.

Factors To Consider When Screening For Growth Stocks

When screening for growth, an investor should look at traditional measures such as projected price/earnings and growth rates. The company/industry growth ratio and the company/S&P 500 growth ratio should also be used. These two ratios allow the screener to compare which companies are growing more than their industry and the overall market. The debt/equity ratio is also important to consider because growth fueled by massive borrowing is likely to be unsustainable. On slip side, companies with strong cash flows can grow systemically for some time.

In term of market capitalization, in looking for growth, an investor’s bias for finding winning stocks should be in the small cap arena. (Small cap is defined as equities having a market capitalization between $100million and $1 billion, so micro cap stocks are not included in this category.) Yes, small cap stocks are risky. Yes, they are less liquid than large cap issue. Yes, there are some high quality large cap growth stocks that will earn attractive returns. The chance, however, of getting gargantuan returns with large cap growth stocks is somewhat limited. Many of these stocks have had their big upward stock move already.

Once a business reaches a certain size, it takes much more effort and is far more difficult to grow earnings and revenues than when it was a smaller entity. The easy growth is over. If Pfizer (PFE) or Merck (MRK) comes out with a new wonder drug that cures AIDS, the effect it will have on their stock prices will be much less than if a small pharmaceutical firm produced the drug. Futhermore, large companies are less flexible and nimble. They tend to be more conservative and set in their ways. It’s much harder to turn a cruise liner than a speedboat. The trick is to find quality small to mid cap companies that have good financial statistics, a workable business model, and a management team that is sharesholder friendly.

It is much easier to grow sales and earnings over a longer period of time from a smaller base. For a larger cap company to continue its sales and earnings gains is very difficult. It is the same percentage gain to go from $1 million in sales to $2 million as it is from $1 billion to $2 billion. Eventually, businesses reach a saturation point. How much more can companies like Microsoft (MSFT) and McDonald’s (MCD) grow? It’s already at the point where they are practically in every computer and in every town.

“I think you have a learn that there’s a company behind every stock, and that there’s only one real reason why stocks go up. Companies go from doing poorly to doing well or small companies grow to large companies.

–Peter Lynch

——– Written by Michael Kaye, CFA

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