05) Stock Picking Strategies: Growth Investing

by · October 16, 2010

When the technological boom happened in the late 90’s, it gave rise to growth investing and  gave investors unprecedented returns.  But before you join the growth investment market, here are some things you need to know.

Growth VS Value

Let’s compare growth investing to value investing to better understand the latter.  Value investing is focused on the current.  It looks for companies that trade below their actual value.  Growth investors, are the opposite, they look towards the future value or potential of a company.  Its current value is not an issue.  Growth investors look for companies that trade higher than their intrinsic value.  For them, they believe that the company’s worth will grow and will therefore exceed their current prices.

Growth investors look at young companies and how much they grow compared to others.  In theory, a young company’s rapid growth translates to more profits and revenue which in turn means an increase in their stock price.  Growth investors look towards the new technology industry. Profits are realized through capital gains and not dividends.

Formula

Growth investors do not rely on a formula for their stock picking.  They are more concerned about a company’s future growth potential.  Picking growth stocks is usually a combination of individual interpretation and judgment.  Investors look at a company’s past performance in relation to the industry’s performance and this usually serves as a basic guideline for growth investors.

NAIC

The National Association of Investors Corporation (NAIC) teaches growth investment.  They teach investors how to invest wisely. Here are some of their guidelines in picking growth stocks:

1.    Strong Historical Earnings Growth

Has the company been growing in the past?  According to the NAIC, this should be the first question a growth investor asks.  if the company displays good growth over the last 10 year period, then it is likely to do so over the next 5-10 years.

2.    Strong forward earnings growth

The NAIC projects that a growth of 10-12% is good but 15% or more is ideal.  The big problem however is that these figures are usually estimates.  So before trusting an estimate, an investor should first look into its credibility.  This requires knowledge in the different growth rates of companies in different industries.

3.    Is management controlling cost and revenue?

Look at  a company’s pre-tax profit margin.  High revenue growth is good but if EPS does not increase proportionately, this is probably due to low profit margin.

By comparing past profit margins an investor can have a good gauge whether or not management is controlling cost and revenue and profit margin.  A good rule of the thumb: companies that exceed their previous 5 years pretax profit margin as well as those in the industry are good buys.

4.    Can management operate the business efficiently?

Compare ROE or return on equity.  Efficient use of assets should be reflected in a solidly increasing ROE.   Take a look at the past 5 years’ ROE and compare to the industry.

5.    Can the stock double in 5 years?

If a stock cannot double in 5 years, then this is not a growth stock.  Remember that growth investors look to 15% growth per annum, which means a doubling in price in five years.

Conclusion

Growth investors are concerned with, obviously, growth.  They look for a company’s potential to grow and expand.  This ensures that the company pays off in the future.

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