Balancing growth and value
Figuring out how to choose growth stocks
Looking at small caps and other speculative investments
What's the number one reason people invest in stocks? To grow their wealth (also referred to as capital appreciation). Yes, some people invest for income (in the form of dividends), but that's a different matter (I discuss investing for income in Chapter 9). Investors seeking growth would rather see the money that could have been distributed as dividends be reinvested in the company so that (hopefully) a greater gain is achieved by seeing the stock's price rise or appreciate. People interested in growing their wealth see stocks as one of the convenient ways to do it. Growth stocks tend to be riskier than other categories of stocks, but they offer excellent long-term prospects for making the big bucks. If you don't believe me, just ask Warren Buffett, Peter Lynch, and other successful, long-term investors.
Although someone like Buffett is not considered a growth investor, his long-term, value-oriented approach has been a successful growth strategy. If you're the type of investor who has enough time to let somewhat risky stocks trend upward or who has enough money so that a loss won't devastate you financially, then growth stocks are definitely for you. As they say, no guts, no glory. The challenge is to figure out which stocks make you richer quicker; I give you tips on how to do so in this chapter.
Note
Short of starting your own business, stock investing is the best way to profit from a business venture. I want to emphasize that to make money in stocks consistently over the long haul, you must remember that you're investing in a company; buying the stock is just a means for you to participate in the company's success (or failure). Why does it matter that you think of stock investing as buying a company versus buying a stock? Invest in a stock only if you're just as excited about it as you would be if you were the CEO and in charge of running the company. If you're the sole owner of the company, do you act differently than one of a legion of obscure stockholders? Of course you do. As the firm's owner, you have a greater interest in the company. You have a strong desire to know how the enterprise is doing. As you invest in stocks, make believe that you're the owner, and take an active interest in the company's products, services, sales, earnings, and so on. This attitude and discipline can enhance your goals as a stock investor. This approach is especially important if your investment goal is growth.
Note
A stock is considered a growth stock when it's growing faster and higher than the overall stock market. Basically, a growth stock performs better than its peers in categories such as sales and earnings. Value stocks are stocks that are priced lower than the value of the company and its assets — you can identify a value stock by analyzing the company's fundamentals and looking at key financial ratios, such as the price-to-earnings ratio. (For more on the topic of ratios, see Appendix B.) Growth stocks tend to have better prospects for growth for the immediate future (from one to four years), but value stocks tend to have less risk and more steady growth over a longer term.
Over the years, a debate has quietly raged in the financial community about growth versus value investing. Some people believe that growth and value are mutually exclusive. They maintain that large numbers of people buying stock with growth as the expectation tend to drive up the stock price relative to the company's current value. Growth investors, for example, aren't put off by price-to-earnings (P/E) ratios of 30, 40, or higher. Value investors, meanwhile, are too nervous buying a stock at those P/E ratio levels.
However, you can have both. A value-oriented approach to growth investing serves you best. Long-term growth stock investors spend time analyzing the company's fundamentals to make sure that the company's growth prospects lie on a solid foundation. But what if you have to choose between a growth stock and a value stock? Which do you choose? Seek value when you're buying the stock and analyze the company's prospects for growth. Growth includes but is not limited to the health and growth of the company's specific industry, the economy at large, and the general political climate (see Chapters 10, 13, 14, and 15).
Note
The bottom line is that growth is much easier to achieve when you seek solid, value-oriented companies in growing industries. To better understand industries and how they affect stock value, see Chapter 13.
Note
Value-oriented growth investing probably has the longest history of success compared to most stock investing philosophies. The track record for those people who use value-oriented growth investing is enviable. Warren Buffett, Benjamin Graham, John Templeton, and Peter Lynch are a few of the more well-known practitioners. Each may have his own spin on the concepts, but all have successfully applied the basic principles of value-oriented growth investing over many years.
Although the information in the previous section can help you shrink your stock choices from thousands of stocks to maybe a few dozen or a few hundred (depending on how well the general stock market is doing), the purpose of this section is to help you cull the so-so growth stocks to unearth the go-go ones. It's time to dig deeper for the biggest potential winners. Keep in mind that you probably won't find a stock to satisfy all the criteria presented here. Just make sure that your selection meets as many criteria as realistically possible. But hey, if you do find a stock that meets all the criteria cited, buy as much as you can!
For the record, my approach to choosing a winning growth stock is probably almost the reverse method of . . . uh . . . that screaming money guy on TV (I won't mention his name!). People watch his show for "tips" on "hot stocks." The frenetic host seems to do a rapid-fire treatment of stocks in general. You get the impression that he looks over thousands of stocks and says "I like this one" and "I don't like that one." The viewer has to decide. Sheesh.
Verifiably, 80 to 90 percent of my stock picks are profitable. People ask me how I pick a winning stock. I tell them that I don't just pick a stock and hope that it does well. In fact, my personal stock-picking research doesn't even begin with stocks; I first look at the investing environment (politics, economics, demographics, and so on) and choose which industry will benefit. After I know which industry will benefit and prosper accordingly, then I start to analyze and choose my stock(s).
After I choose a stock, I wait. Patience is more than just a virtue; it is to investing what time is to a seed that is planted in fertile soil. The legendary Jesse Livermore said that he didn't make his stock market fortunes by trading stocks; his fortunes were made "in the waiting." Why?
When I tell you to have patience and a long-term perspective, it isn't because I want you to wait years or decades for your stock portfolio to bear fruit. It's because you're waiting for a specific condition to occur: when the market discovers what you have! When you have a good stock in a good industry, it takes time for the market to discover it. The simple act that makes a stock rise is when it has more buyers than sellers. As time passes, more buyers find your stock. As the stock rises, this attracts more attention and therefore more buyers. The more time that passes, the better your stock looks to the investing public.
Note
When you're choosing growth stocks, you should consider investing in a company only if it makes a profit and if you understand how it makes that profit and from where it generates sales. Part of your research means looking at the industry (see Chapter 13) and economic trends in general.
A strong company in a growing industry is a common recipe for success. If you look at the history of stock investing, this point comes up constantly. Investors need to be on the alert for megatrends because they help ensure success.
A megatrend is a major development that has huge implications for much (if not all) of society for a long time to come. Good examples are the advent of the Internet and the aging of America. Both of these trends offer significant challenges and opportunities for our economy. Take the Internet, for example. Its potential for economic application is still being developed. Millions are flocking to it for many reasons. And census data tells us that senior citizens (over 65) will be the fastest-growing segment of our population during the next 20 years. How does the stock investor take advantage of a megatrend?
In 2008, the big news was the credit crisis that slammed the stock markets (in the U.S. and across the globe). A megatrend — indebtedness to the tune of trillions — hit as predicted in the previous edition of Stock Investing For Dummies. Investors who stayed alert were able to get their money out of harm's way by moving it out of sectors most affected by the credit crisis, such as bank and brokerage stocks. Stocks tied to human need (such as food and water) fared much better as a group.
In this 3rd edition, I plan to do what I did in the 2nd edition, which is to help you identify the megatrends that are in place to make it easier for you to pick winning stocks (you're welcome!). For emerging megatrends, check out Chapter 14.
You have to measure the growth of a company against something to figure out whether it's a growth stock. Usually, you compare the growth of a company with growth from other companies in the same industry or with the stock market in general. In practical terms, when you measure the growth of a stock against the stock market, you're actually comparing it against a generally accepted benchmark, such as the Dow Jones Industrial Average (DJIA) or the Standard & Poor's 500 (S&P 500). For more on DJIA and S&P 500, see Chapter 5.
If a company has earnings growth of 15 percent per year over three years or more and the industry's average growth rate over the same time frame is 10 percent, then the stock qualifies as a growth stock. You can easily calculate the earnings growth rate by comparing a company's earnings in the current year and previous year and computing the difference as a percentage. For example, if the company's earnings (on a per share basis) were $1 last year and $1.10 this year, then earnings grew by 10 percent. Many analysts also look at a current quarter and compare the earnings to the same quarter from the previous year to see if earnings are growing.
Note
A growth stock is called that not only because the company is growing but also because the company is performing well with some consistency. Having a single year where your earnings do well versus the S&P 500's average doesn't cut it. Growth must be consistently accomplished.
Tip
Companies that have established a strong niche are consistently profitable. Look for a company with one or more of the following characteristics:
A strong brand: Companies such as Coca-Cola and Microsoft come to mind. Yes, other companies out there can make soda or software, but a business needs a lot more than a similar product to topple companies that have established an almost irrevocable identity with the public.
High barriers to entry: United Parcel Service and Federal Express have set up tremendous distribution and delivery networks that competitors can't easily duplicate. High barriers to entry offer an important edge to companies that are already established. Examples of high barriers include high capital requirements (needing lots of cash to start) or special technology that's not easily produced or acquired.
Research and development (R&D): Companies such as Pfizer and Merck spend a lot of money researching and developing new pharmaceutical products. This investment becomes a new product with millions of consumers who become loyal purchasers, so the company's going to grow. You can find out what companies spend on R&D by checking their financial statements and their annual reports (more on this in Chapter 12).
Note
When you hear the word fundamentals in the world of stock investing, it refers to the company's financial condition and related data. When investors (especially value investors) do fundamental analysis, they look at the company's fundamentals — its balance sheet, income statement, cash flow, and other operational data, along with external factors such as the company's market position, industry, and economic prospects. Essentially, the fundamentals indicate the company's financial condition. Chapter 11 goes into greater detail about analyzing a company's financial condition. However, the main numbers you want to look at include the following:
Sales: Are the company's sales this year surpassing last year's? As a decent benchmark, you want to see sales at least 10 percent higher than last year. Although it may differ depending on the industry, 10 percent is a reasonable, general yardstick.
Earnings: Are earnings at least 10 percent higher than last year? Earnings should grow at the same rate as sales (or, hopefully, better).
Debt: Is the company's total debt equal to or lower than the prior year? The death knell of many a company has been excessive debt.
A company's financial condition has more factors than I mention here, but these numbers are the most important. I also realize that using the 10 percent figure may seem like an oversimplification, but you don't need to complicate matters unnecessarily. I know someone's computerized financial model may come out to 9.675 percent or maybe 11.07 percent, but keep it simple for now.
The management of a company is crucial to its success. Before you buy stock in a company, you want to know that the company's management is doing a great job. But how do you do that? If you call up a company and ask, it may not even return your phone call. How do you know whether management is running the company properly? The best way is to check the numbers. The following sections tell you the numbers you need to check. If the company's management is running the business well, the ultimate result is a rising stock price.
Note
Although you can measure how well management is doing in several ways, you can take a quick snapshot of a management team's competence by checking the company's return on equity (ROE). You calculate the ROE simply by dividing earnings by equity. The resulting percentage gives you a good idea whether the company is using its equity (or net assets) efficiently and profitably. Basically, the higher the percentage, the better, but you can consider the ROE solid if the percentage is 10 percent or higher. Keep in mind that not all industries have identical ROEs.
To find out a company's earnings, check out the company's income statement. The income statement is a simple financial statement that expresses this equation: sales (or revenue) less expenses equal net earnings (or net income or net profit). You can see an example of an income statement in Table 8-1. (I give more details on income statements in Chapter 11).
Table 8-1. Grobaby, Inc., Income Statement
2007 Income Statement | 2008 Income Statement | |
|---|---|---|
Sales | $82,000 | $90,000 |
Expenses | −$75,000 | −$78,000 |
Net earnings | $7,000 | $12,000 |
To find out a company's equity, check out that company's balance sheet. (See Chapter 11 for more details on balance sheets.) The balance sheet is actually a simple financial statement that illustrates this equation: total assets minus total liabilities equal net equity. For public stock companies, the net assets are called "shareholders' equity" or simply "equity." Table 8-2 shows a balance sheet for Grobaby, Inc.
Table 8-1 shows that Grobaby's earnings went from $7,000 to $12,000. In Table 8-2, you can see that Grobaby increased the equity from $35,000 to $40,000 in one year. The ROE for the year 2007 is 20 percent ($7,000 in earnings divided by $35,000 in equity), which is a solid number. The following year, the ROE is 30 percent ($12,000 in earnings divided by $40,000 equity), another solid number. A good minimum ROE is 10 percent, but 15 percent or more is preferred.
Two additional barometers of success are a company's growth in earnings and growth of equity.
Look at the growth in earnings in Table 8-1. The earnings grew from $7,000 (in 2007) to $12,000 (in 2008), or a percentage increase of 71 percent ($12,000 less $7,000 equals $5,000, and $5,000 divided by $7,000 is 71 percent), which is excellent. At a minimum, earnings growth should be equal or better to the rate of inflation, but because that's not always a reliable number, I like at least 10 percent.
In Table 8-2, Grobaby's equity grew by $5,000 (from $35,000 to $40,000), or 14 percent, which is very good — management is doing good things here. I like to see equity increasing by 10 percent or better.
Tip
Watching management as it manages the business is important, but another indicator of how well the company is doing is to see whether management is buying stock in the company as well. If a company is poised for growth, who knows better than management? And if management is buying up the company's stock en masse, then that's a great indicator of the stock's potential. See Chapter 20 for more details on insider buying.
Tip
You can invest in a great company and still see its stock go nowhere. Why? Because what makes the stock go up is demand — having more buyers than sellers of the stock. If you pick a stock for all the right reasons and the market notices the stock as well, that attention causes the stock price to climb. The things to watch for include the following:
Institutional buying: Are mutual funds and pension plans buying up the stock you're looking at? If so, this type of buying power can exert tremendous upward pressure on the stock's price. Some resources and publications track institutional buying and how that affects any particular stock. (You can find these resources in Appendix A.) Frequently, when a mutual fund buys a stock, others soon follow. In spite of all the talk about independent research, a herd mentality still exists.
Analysts' attention: Are analysts talking about the stock on the financial shows? As much as you should be skeptical about an analyst's recommendation (given the stock market debacle of 2000–2002 and the market problems in 2008), it offers some positive reinforcement for your stock. Don't ever buy a stock solely on the basis of an analyst's recommendation. Just know that if you buy a stock based on your own research, and analysts subsequently rave about it, your stock price is likely to go up. A single recommendation by an influential analyst can be enough to send a stock skyward.
Newsletter recommendations: Independent researchers usually publish newsletters. If influential newsletters are touting your choice, that praise is also good for your stock. Although some great newsletters are out there (find them in Appendix A) and they offer information that's as good or better than the research departments of some brokerage firms, don't use a single tip to base your investment decision on. But it should make you feel good if the newsletters tout a stock that you've already chosen.
Consumer publications: No, you won't find investment advice here. This one seems to come out of left field, but it's a source that you should notice. Publications such as Consumer Reports regularly look at products and services and rate them for consumer satisfaction. If a company's offerings are well received by consumers, that's a strong positive for the company. This kind of attention ultimately has a positive effect on that company's stock.
A company's financial situation does change, and you, as a diligent investor, need to continue to look at the numbers for as long as the stock is in your portfolio. You may have chosen a great stock from a great company with great numbers in 2006, but chances are pretty good that the numbers have changed since then.
Warning
Great stocks don't always stay that way. A great selection that you're drawn to today may become tomorrow's pariah. Information, both good and bad, moves like lightning. Keep an eye on your stock company's numbers! To help minimize the downside risk, see the nearby sidebar for an example. For more information on a company's financial data, check out Chapter 11.
A growth stock isn't a creature like the Loch Ness monster — always talked about but rarely seen. Growth stocks have been part of the financial scene for nearly a century. Examples abound that offer rich information that you can apply to today's stock market environment. Look at past market winners, especially those of the 1970s and 1980s, and ask yourself, "What made them profitable stocks?" I mention these two decades because they offer a stark contrast to each other. The '70s were a tough, bearish decade for stocks, while the '80s were booming bull times. (See Chapter 14 for details on bear and bull markets.)
Note
Being aware and acting logically is as vital to successful stock investing as it is to any other pursuit. Over and over again, history gives you the formula for successful stock investing:
Pick a company that has strong fundamentals, including signs such as rising sales and earnings and low debt. (See Chapter 11).
Make sure that the company is in a growing industry. (See Chapter 13).
Be fully invested in stocks during a bull market, when prices are rising in the stock market and in the general economy. (See Chapter 14).
During a bear market, switch more of your money out of growth stocks (such as technology) and into defensive stocks (such as utilities).
Monitor your stocks. Hold onto stocks that continue to have growth potential, and sell those stocks with declining prospects. (See Chapter 24 for some red flags for stock investors.)
Everyone wants to get in early on a hot new stock. Why not? You buy Shlobotky, Inc., at $1 per share and hope it zooms to $98 before lunchtime. Who doesn't want to buy a stock that could become the next IBM or Microsoft? This possibility is why investors are attracted to small cap stocks.
Small cap (or small capitalization) is a reference to the company's market size, as I explain in Chapter 1. Small cap stocks are stocks that have a market value under $1 billion. Investors may face more risk with small caps, but they also have the chance for greater gains.
Out of all the types of stocks, small cap stocks continue to exhibit the greatest amount of growth. In the same way that a tree planted last year has more opportunity for growth than a mature 100-year-old redwood, small caps have greater growth potential than established large cap stocks. Of course, a small cap doesn't exhibit spectacular growth just because it's small. It grows when it does the right things, such as increasing sales and earnings by producing goods and services that customers want.
Note
For every small company that becomes a Fortune 500 firm, hundreds of companies don't grow at all or go out of business. When you try to guess the next great stock before any evidence of growth, you're not investing — you're speculating. Have you heard that one before? (If not, flip to Chapter 2 for details.) Of course you have, and you'll hear it again. Don't get me wrong — there's nothing wrong with speculating. But it's important to know that you're speculating when you're doing it. If you're going to speculate in small stocks hoping for the next Google, then use the guidelines I present in the following sections to increase your chances of success.
Initial public offerings (IPOs) are the birthplace of public stocks, or the proverbial ground floor. The IPO is the first offering to the public of a company's stock. The IPO is also referred to as "going public." Because a company's going public is frequently an unproven enterprise, investing in an IPO can be risky. Here are the two types of IPOs:
Start-up IPO: This is a company that didn't exist before the IPO. In other words, the entrepreneurs get together and create a business plan. To get the financing they need for the company, they decide to go public immediately by approaching an investment banker. If the investment banker thinks that it's a good concept, the banker will seek funding (selling the stock to investors) via the IPO.
A private company that decides to go public: In many cases, the IPO is done for a company that already exists and is seeking expansion capital. The company may have been around for a long time as a smaller private concern, but it decides to seek funding through an IPO to grow even larger (or to fund a new product, promotional expenses, and so on).
Which of the two IPOs do you think is less risky? That's right — the private company going public. Why? Because it's already a proven business, which is a safer bet than a brand-new start-up. Some great examples of successful IPOs in recent years are United Parcel Service and Google (they were both established companies before they went public).
Great stocks started as small companies going public. You may be able to recount the stories of Federal Express, Dell, AOL, Home Depot, and hundreds of other great successes. But do you remember an IPO by the company Lipschitz & Farquar? No? I didn't think so. It's among the majority of IPOs that don't succeed.
Warning
IPOs have a poor track record of success in their first year. Studies periodically done by the brokerage industry have revealed that IPOs (more times than not) actually decline in price 60 percent of the time during the first 12 months. In other words, an IPO has a better than even chance of dropping in price. For investors, the lesson is clear: Wait until a track record appears before you invest in a company. If you don't, you're simply rolling the dice (in other words, you're speculating, not investing!). Don't worry about missing that great opportunity; if it's a bona fide opportunity, you'll still do well after the IPO.
I emphasize two points when investing in stocks:
Make sure that a company is established. (Being in business for at least three years is a good minimum.)
Make sure that a company is profitable.
These points are especially important for investors in small stocks. Plenty of start-up ventures lose money but hope to make a fortune down the road. A good example is a company in the biotechnology industry. Biotech is an exciting area, but it's esoteric, and at this early stage, companies are finding it difficult to use the technology in profitable ways. You may say, "But shouldn't I jump in now in anticipation of future profits?" You may get lucky, but understand that when you invest in unproven, small cap stocks, you're speculating.
The only difference between a small cap stock and a large cap stock is a few zeros in their numbers and the fact that you need to do more research with small caps. By sheer dint of size, small caps are riskier than large caps, so you offset the risk by accruing more information on yourself and the stock in question. Plenty of information is available on large cap stocks because they're widely followed. Small cap stocks don't get as much press, and fewer analysts issue reports on them. Here are a few points to keep in mind:
Warning
Understand your investment style. Small cap stocks may have more potential rewards, but they also carry more risk. No investor should devote a large portion of his capital to small cap stocks. If you're considering retirement money, you're better off investing in large cap stocks, exchange-traded funds (ETFs), investment-grade bonds, bank accounts, and mutual funds. For example, retirement money should be in investments that are either very safe or have proven track records of steady growth over an extended period of time (five years or longer).
Check with the Securities and Exchange Commission (SEC). Get the financial reports that the company must file with the SEC (such as its 10Ks and 10Qs — see Chapter 6 for more details). These reports offer more complete information on the company's activities and finances. Go to the SEC Web site at
www.sec.govand check its massive database of company filings at EDGAR (Electronic Data Gathering, Analysis, and Retrieval system). You can also check to see whether any complaints have been filed against the company.Check other sources. See whether brokers and independent research services, such as Value Line, follow the stock. If two or more different sources like the stock, it's worth further investigation. Check the resources in Appendix A for further sources of information before you invest.