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Don't worry if you're
having trouble getting a grip on the concept of sustainable growth.
it's a lot harder to scope out a growth stock than to identify
promising income or value stocks That's why there are so few
brilliant growth stock pickers and lots of managers who can choose a
solid portfolio of cheap stocks with attractive yields.
However, while growth
investing is the hardest to do well and the riskiest if you make a
mistake it also offers the biggest pay- off by far.
I'm not suggesting
that reading a single book, can make you infallible. But once you know
what qualities a company needs if it's going to sizzle, you should be
able to improve your odds of spotting winners and avoiding pumped up
growth stocks that can suddenly run out of steam and crash in
price.-lo make it easier to apply these ideas to practical stock
selection, I've tried to summarize the characteristics of a winning
growth stock in the following checklist. Next time, before you buy,
ask yourself these questions: * Does the company have a unique
product or service? Growth stocks have to earn above average profits
for that for any length of time, a company must offer an
innovative and valuable product or service that is not readily
available elsewhere?
Since all
growth stocks eventually exhaust their markets, make sure that you are
getting in on a company when it is still in the early part of its
growth curve.
Beware especially if everyone is familiar with the company knows about
its success, and blandly assumes that it will grow forever.
Is the company at the
forefront of its industry? Remember that when an industry is booming,
there is no guarantee that all the companies in it will continue to
prosper. For example, despite the explosion in sales of computers over
the past 10 years, both IBM and Digital Equipment shares collapsed in
the early '90S because the companies were heavily dependent on sales
of large computers and no longer at the leading edge of the
technology.
The return on equity
higher than 15%? Even if a company isn't paying any dividends, it
generally needs a return on equity of 15% or more to sustain an
earnings growth rate of 12% or more. and without average long-term
profit increases of at least that much, you aren't dealing with a true
growth stock.
|Is the company's debt low-or at least stable? The best growth Stocks
have no debt.
For GROWTH
Able to fund its
expansion internally. Next best is if the company has debt less than
20% of its long-term capital (which consists of equip plus long-term
debt). Companies whose debt is only a fraction of their capital have
no immediate barriers to growth since they could increase their
borrowing for two or three years and still have debt below 50%. The
stocks you have to worry about are those where debt exceeds equity
that is, where debt is more than 50% of capital and where the debt
ratio has been rising steadily. Such firms may be trying to expand
faster than their natural growth rates, using borrowing to make up for
inadequate profitability | Does the firm have a valuable franchise,
brand name, proprietary technology, or patents? Companies can continue
to earn profits as long as they can prevent competitors from
undercutting their prices. It's most desirable, therefore, for a
company to have some intrinsic advantage-whether it's a widely
recognized brand name or proprietary technology-that serves as a
barrier against other companies that would like to enter the industry.
Otherwise a firm's power depends on the quality of its management-and
that's an edge that can easily be overcome by hungry competitors.
Is the stock's
price/earnings ratio lower than its earnings growth rate? Growth
investors are best advised to choose companies based on their
potential for increases in net income rather than their share prices.
Still, stock valuation is important.
If you overpay for a
stock, your future capital gains will be smaller even if earnings go
up as expected. And your risk will be bigger, too. Here's one test 1
recommend to check that a stock is reasonably priced: The
price/earnings ratio should be lower than the stock's projected annual
earnings growth rate. In other words, if a company's profits are
expected to rise 25% a year, on average, you shouldn't buy it if the
price is more than 25 times analysts' estimates of earnings per share
for the current Year.
* Is the PZE less than 20?
Studies have shown that stocks with moderate growth prospects (15% to
20% a year) on average out- perform those with the highest projected
growth rates (20%- plus). How can that be? The answer is that
high-yielding stocks are riskier and more likely to disappoint
investors than shares with more reasonable objectives. A good way to
be sure that you focus on the safer sort of growth stock is to shy
away from issues with price/earnings ratios above 20. lf you want to
include some maximum-growth stocks in your portfolio, you might be
smarter buying a broadly diversified mutual fund that holds Such
issues.
Do you believe the
share price can double in five years? A stock that can meet the sorts
of tests we've just described should be able to double in price over
five years. To be exact, if a company's earnings per share increase at
a 15% rate and the stock's price/earnings ratio remains constant at
15, the share price will gain 101% over five years. lf you have
questions about whether a firm can turn in the earnings needed for a |ve-year
double, then check your calculations, because something's wrong.
* Is the PZE less than 20?
Studies have shown that stocks with moderate growth prospects (15% to
20% a year) on average out- perform those with the highest projected
growth rates (20%- plus). How can that be? The answer is that high-|ying
stocks are riskier and more likely to disappoint investors than shares
with more reasonable objectives. A good way to be sure that you focus
on the safer sort of growth stock is to shy away from issues with
price/earnings ratios above 20. lf you want to include some
maximum-growth stocks in your portfolio, you might be smarter buying a
broadly diversified mutual fund that holds Such issues.
Do you believe the
share price can double in five years? A stock that can meet the sorts
of tests we've just described should be able to double in price over
five years. To be exact, if a company's earnings per share increase at
a 15% rate and the stock's price/earnings ratio remains constant at
15, the share price will gain 101% over five years. lf you have
questions about whether a firm can turn in the earnings needed for a
five year double, then check your calculations, because something's
wrong. |
