3 Tips for Picking Winning Growth Stocks

Source: Thinkstock

Source: Thinkstock

As a young investor, I like to own growth stocks. I want to own pieces of companies that are growing their footprint in the global economy and earn money doing so. But there are a lot of growth stocks out there, and if you pick the wrong ones, you can get hurt badly. These stocks fall hard when investors become concerned that they can no longer generate revenue and profit growth. Therefore, I have come up with these three general rules for picking growth stocks that are likely to be winners. I know I won’t be right 100 percent of the time, but they give me an edge.

1. Valuation Matters

There is a false dichotomy in Wall Street lingo that there are “growth stocks” and then there are “value stocks.” This is rubbish — you should only buy a stock that offers good value regardless of its growth. The distinction that is being made refers to stocks that trade at high p/e multiples in virtue of their growth rates, and stocks that trade at low p/e multiples without any growth but which generate regular profits and income.

How, then, do we determine whether a growth stock offers good value? A good rule of thumb is to look at its “PEG” ratio, where the “PE” stands for the p/e ratio and the “G” stands for the growth rate. Specifically, you divide a company’s p/e ratio by its projected growth rate. Generally, a growth stock is going to be a solid investment if its PEG ratio is 1 or less, meaning its p/e ratio is equal to or below its growth rate. The same stock is not worth buying if its PEG ratio is anywhere greater than 1.5, and it is worth selling, no matter how much you like the company, at a PEG ratio of 2.

So, for instance, MasterCard (NYSE:MA) has an historical growth rate of about 20 percent. Since its growth is decelerating, and since its primary competitor — Visa (NYSE:V) — released earnings figures that suggest decelerating growth, we can conservatively project that MasterCard’s growth rate is about 18 percent. MasterCard trades at 24.4 times 2014 earnings estimates, giving it a PEG ratio of 1.36. This means that the stock offers good value, even though it trades with a relatively high p/e multiple. I wouldn’t buy the stock just yet, although if I owned shares I wouldn’t sell them either.

Source: Thinkstock

Source: Thinkstock

2. Pick Growth Stocks With Secular Tailwinds

While valuation is a major factor in picking a growth stock, there are some growth stocks I simply don’t want to own even if they offer good value. The reason is that they are growing in an industry that isn’t, or one that is extremely competitive. Take Chipotle Mexican Grill (NYSE:CMG) as an example. This company is growing rapidly, but it is doing so in the fast-food restaurant industry. While the industry is growing, it isn’t growing very rapidly. Furthermore, there are hundreds of fast-food chains all over the country vying for your business. While Chipotle is succeeding now, how do I know that it will continue to do so?

On the other hand, take the example of MasterCard again, which is in a growing industry — cashless payment solutions. Not only is this industry growing, but it isn’t very competitive. MasterCard’s only competition comes from American Express (NYSE:AXP), Visa, and Discover Financial (NYSE:DFS). Given that the cashless payment industry is growing, and given that there is very little competition, I am confident in MasterCard’s future growth.

The bottom line is that you need to make sure that you are buying growth stocks in industries in which it is easy for best of breed companies to grow.

Source: Thinkstock

Source: Thinkstock

3. Invest in Best of Breed Companies

Once you’ve discovered a growth industry you want to invest in, you shouldn’t indiscriminately buy all or several of the stocks in that industry group. If you take the time to go through the companies one by one, you will find one or two that stand out as “best of breed” companies. You should own these.

Take, for example, the additive manufacturing industry (or, 3D printing.) There is little doubt that this is a growth industry, and I think investors who want to own growth stocks should familiarize themselves with it. But if you start reading through company reports you’ll find that they are all citing the growth potential of the industry as reasons to invest. Find the companies that have outperformed, that have been able to innovate and take that innovation to the point of sales and profit growth.

In other words, make sure it is really growing. I know that sounds redundant, but consider that there are companies in the additive manufacturing space that aren’t growing their revenues and profits such as Organovo (NYSEMKT:ONVO) — a company that has no sales. Instead, invest in a company such as Stratasys (NASDAQ:SSYS), which is growing sales and building a business that is focusing on benefitting from every aspect of the industry. Note how Stratasys shares are down with the rest of the industry, yet not nearly as much — the stock is off 26 percent for the year versus Organovo, which is off 50 percent. While the downtrend in these stocks may not be over, the market is telling you which are the winners and which are the losers.

Conclusion

If you follow these three tips, you won’t always pick winning growth stocks. But I think most of the time you will.

One more point that I want to make is that each of these three pieces of advice is supposed to be exclusionary — it is meant to help you eliminate potential candidates for your portfolio. Remember that you are building a portfolio of just a handful of stocks out of thousands of possibilities, and that your time is best spend finding reasons not to own a stock than to own it. This is especially true of growth stocks, which have tremendous outward appeal but which also come with significant risk. As long as you can identify and focus on the latter, you will be successful at picking the best growth stocks the market has to offer.

Disclosure: Ben-Kramer Miller is long Visa and Stratasys.

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