A growth approach to investing can help you find stocks with the potential for significant price appreciation, provided the firm is able to meet and exceed its growth expectations and you don't overpay for growth. This strategy produces very little return in the form of dividends and can be volatile because of the large role that expectations play in the pricing of these stocks.
Company Characteristics
Growth companies expand at a rate above that of the overall economy. Practically speaking, however, the minimum benchmark for being classified as a growth stock is at least a 10% annual growth rate in earnings per share, with many investors requiring a 20% annual growth rate. To maintain growth rates this high over any extended period, capital spending is required, and for this reason growth stocks tend to retain most of their earnings, paying little or no cash dividends.
Promising growth stocks attract a great deal of attention, and therefore, prices tend to be bid up with high anticipation. High expectations relative to current levels of earnings lead to high price-earnings ratios, and it is not uncommon to see highly touted growth stocks with price-earnings ratios two to four times that of the market.
As long as the firm maintains its earnings per share momentum and exceeds the growth expectations of the market, its stock price can be expected to increase by quite a bit. However, a small deviation from market expectations during a quarterly earnings announcement can send the price flying in either direction. Thus, while growth stocks have the potential for high returns, they are also high risk.
The Initial List
The first step is drawing up an initial list of promising candidates for further analysis. A growth approach focuses initially on companies that consistently have had above-average earnings growth over the past few years.
An initial list of candidates can be compiled by applying various screens to a database of stocks. See the Stock Ideas area of AAII.com for screens based on the growth approach. You can filter stocks on earnings growth using the screening tools at the sites listed in our Best of Web guide under the Stock Screening category.
In using these lists and screens, be careful that you do not accidentally concentrate on a specific industry. In addition, cyclical companies may turn up on growth lists at certain times if they are in an upswing in their cycle. For this reason, make sure that you examine earnings growth over longer time periods covering at least one economic cycle to make sure you are focusing on true growth companies. Requiring consistently rising earnings each year can also help identify more stable growth companies. Other conditions can help narrow the selection further—for instance, eliminating companies with outrageous price-earnings ratios.
Once a list of candidates is established, the next step is to perform an in-depth evaluation of the stocks on the list to determine the fair market value.
Continue to Step 2 »
