Chapter 8
IN THIS CHAPTER
Balancing growth and value
Using strategies to select good growth stocks
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 when the stock’s price rises or appreciates. 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.
A stock is considered a growth stock when it’s growing faster and at a higher rate 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 (P/E) ratio. (I cover company finances in Chapter 11 and ratios in Chapter 11 and Appendix B.) Growth stocks tend to have better prospects for growth in the immediate future (from one to four years), but value stocks tend to have less risk and steadier 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 P/E ratios of 30, 40, or higher. Value investors, meanwhile, are too nervous to buy stocks 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 13 and 15).
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 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; patience is to investing what time is to a seed that’s 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: for the market to discover what you have! When you have a good stock in a good industry, it takes time for the market to discover it. When a stock has more buyers than sellers, it rises — it’s as simple as that. As time passes, more buyers find your stock. As the stock rises, it attracts more attention and, therefore, more buyers. The more time that passes, the better your stock looks to the investing public.
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 the 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 continue to be a fast-growing segment of the U.S. population during the next 20 years. (Millennials are another huge demographic that investors should be aware of.) How does the stock investor take advantage of a megatrend? Find out more in Chapter 13.
Because small companies can be the ones poised for the most potential growth, check out Chapter 14 to get in early on some hot stocks.
You have to measure the growth of a company against something to figure out whether its stock is 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 stock indexes, see Chapter 5.
Companies that have established a strong niche are consistently profitable. Look for a company with one or more of the following characteristics:
When you hear the word fundamentals in the world of stock investing, it refers to the company’s financial condition, operating performance, 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:
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.
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) minus expenses equals 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
2019 Income Statement | 2020 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 equals 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 8-2 Grobaby, Inc., Balance Sheet
Balance Sheet as of December 31, 2019 | Balance Sheet as of December 31, 2020 | |
Total assets (TA) | $55,000 | $65,000 |
Total liabilities (TL) | –$20,000 | –$25,000 |
Equity (TA minus TL) | $35,000 | $40,000 |
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 2019 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 in 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:
You can invest in a great company and still see its stock go nowhere. Why? Because what makes the stock go up is demand — when there’s more buying than selling 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:
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 2018, but chances are pretty good that the numbers have changed since then.
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 during the bull market of the late 1990s and the bearish markets of 2000–2010, and ask yourself, “What made them profitable stocks?” I mention these two time frames because they offer a stark contrast to each other. The 1990s were booming times for stocks, whereas more recent years were very tough and bearish.
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