CHAPTER 3

Growth Stocks

For executives, it’s hard to see a long-term path to future financial independence without stocks being an important part of the mix in the early going. Whether you are investing in stocks directly (such as in your stock brokerage account) or indirectly (such as through an exchange-traded fund or mutual fund), you will need to understand what they really are (vs. what you may read in popular financial sites), what their purpose is, and how to use them to achieve your financial objectives. Keep in mind that there are different types of stocks that can be applicable for different types of situations.

For the purpose of this book, I will keep the focus on stocks to grow your wealth (during your corporate executive career) and then switch to dividend-paying stocks for your later years when passive income is more suitable (retirement). Secondly, the focus is on long-term investing and not short-term speculating or trading.

The Plan

In a nutshell, here is “the plan” or blueprint I suggest for the stock portion of your portfolio going forward:

“Stocks” Versus “Companies”

When you buy a stock, you are really buying partial ownership in a publicly traded company. It may sound somewhat obvious but it’s not. Stocks (shares of stock) are bought and sold endlessly every day that the stock market is open and it is astonishing how many people buy stocks and don’t realize that you are buying companies—the stock shares are merely a convenient way to participate. The point is that when you make the purchase your focus should be on the underlying company and the financial and market data (the “fundamentals”) to help you analyze the company and make a rational decision about making it part of your investment portfolio.

Long Term Versus Short Term

The world of investing is really a long-term pursuit. When I say “long term” I do mean (ideally) five years or longer. If your timeframe is less than that, then stocks (especially those chosen for growth or “capital appreciation”) may not have adequate time to bear profitable fruit. If your timeframe is one year or less, then avoid stocks. If your timeframe is two to five years, then you are better off with stocks that are more stable and also offer dividend income such as in public companies in industries such as utilities or consumer staples (also referred to as “defensive stocks”).

Why five years? There is no magic in the timeframe beyond giving the marketplace adequate time to discover the gem you invested in so that market-buying interest propels the stock price to higher levels. One of my clients chose a “boring” water stock. Yet 10 years later, that stock was up 450 percent. That doesn’t include the dividends that reliably came in quarter after quarter. The point is that quality stocks that grab the interest of the stock-buying public don’t typically happen in a day or a week or a month. Reliable, quality companies ultimately attract greater interest over time, and your patience and diligence gets rewarded with huge percentage gains eventually. I recall one student from my class that bought a stock looking for a “quick killing” and then getting annoyed with a meager gain. Some years later he attended another class of mine and regretted not holding on to the stock as it grew by over 900 percent a few years later!

Just keep in mind that the time factor is more about giving your stock enough time to reach new heights as the market discovers it and not necessarily a strict condition of “calendar time.”

Additionally, you need time since market and economic conditions change constantly. The folks that bought stocks right before the 2008 market crash saw their stocks plummet in the short term but with patience and discipline saw those same stocks hit all-time highs only a few short years later. Lastly, long-term investing is a much more assured way of achieving gains than trying to outmaneuver the market in the short term. Short-term trading and speculating is fraught with land mines as markets can “zig” as you “zag” and vice versa. I have seen all types of insanity in the short-term gyrations of the market. But in long-term investing, rational decisions do ultimately result in rational outcomes. Long term, the price of stocks of quality companies will zig-zag upward while the price of stocks of failing companies will zig-zag downward.

Given that, let’s look at the “fundamentals,” which tell you how strong the underlying company is and the prospects for a bright future for its stock.

Fundamental Analysis Versus Technical Analysis

When it comes to long-term investing, fundamental analysis or “looking at the fundamentals” is the name of the game. Yes, there is also “technical analysis” but that is more relevant for shorter term trading and/or speculating. Before we go further, let’s define these terms.

Fundamental analysis looks at the company’s financial strength and their standing in the industry/sector. Fundamental analysis looks at the company’s profitability and sales data (such as their income statement) and the company’s assets, liabilities, and net equity (such as on their balance sheet). Market data also comes into play as we look at the company’s prospects in the industry and their market share. We also look at the company’s numbers and analyze them to learn about the company’s profitability, solvency, efficiency, and so on using ratios and other analytical tools.

Technical analysis looks more at the relatively short-term gyrations of the stock’s price through the prism of price movements, charts, moving averages, trading volume data, and so on. While fundamental analysis focuses on the company, technical analysis focuses more on the stock’s price and its movement especially over the short term (typically measured in days and weeks). It is beyond the scope of this book to get into greater details about these topics but there will be resources at the end of the chapter if you want to drill down on them. I will only focus on some key points in this chapter.

Because we are looking at long-term investing, I will only cover the most important fundamentals that are critical for success.

In a nutshell, fundamental analysis is about the “what,” while technical analysis is about the “when.” Fundamentals help determine what you will invest in for the long term while technical analysis helps you figure out when to buy or sell in the short term.

Key Fundamentals

Here are the main things I look at when I am deciding on the stock of a particular company:

There … kept it simple. Yes. There is more but these are the most important things I look at before I even consider a single share of their stock. Now let’s look at some key ratios.

Key Fundamental Ratios

Ratios are simply numbers that have an important relationship to help you understand the strengths (or weaknesses) of the company’s financial standing. Here are some I usually look at.

Price/Earnings Ratio

When I’m looking at a particular company, one of the most important ratios that I will look at is the price/earnings ratio. And it is something that I think everyone should be reviewing, especially if you’re considering purchasing the stock of a company that is going to be in your portfolio for the long term, not only for the point of view of being a value-oriented approach, but also because it has a measure of safety; otherwise you might not realize that the price/earnings ratio is one of the few ratios that try to bridge those two worlds of the stock. As I mentioned earlier in this chapter, you have the stock and you have the underlying company.

Sometimes the stock will act without logic or reason in the marketplace in a given trading day or week. And what seems like erratic and uncoupled ways from the stock from the company itself. The Company is what we all know: it’s a physical entity, by and large; even if it’s an online company, you have people, you have products, you have services, you have financial statements, you have an enterprise, a physical enterprise, and the company is what you’re actually looking at when you are thinking about investing.

Don’t confuse investing and investors with the people out there who do things such as day trading, or swing trading, or speculating and using technical analysis and jumping in and jumping out. That’s a different animal altogether. And I don’t think that’s really an appropriate pursuit, certainly not in this book. And if the corporate executives want to do the trading and jumping in and jumping out, you know that’s a form of speculation, really, and there’s nothing wrong with that. But again, it’s outside the scope and purpose and goals of this particular book. I believe that long-term investing is a more assuring way of going forward. I’ve seen too often that people, whether they are corporate executives or common investors, or hedge funds have just gone into the excess and traded with companies and ended up losing thousands or millions or even billions. And if all they did was to view the stock through the prism, what about what investors should be viewing, which is the company itself, its sales, its profits, its prospects in the marketplace; we want to look at the company. But of course, to participate with the company, you ultimately have to buy the stock. And sometimes you have situations where the company is solid and good, but the stock price goes down (temporarily).

Or you’ll see situations where the company is not that short of a footing, maybe it is even in financial difficulty, yet its stock price goes up. So the short term tends to be very irrational. But what you end up finding out is that a solid company ultimately will see value in its stock over the long term. In other words, the value of the company and the value of the stock, ultimately, in the long term, come to a mutual point. Bad companies ultimately will see their stocks go down in the long term; good companies will ultimately see their stocks zig-zagging upward in the long term. So finding tangible solid relationships between the stock and the company is very important. For me as a speculator sometimes, I’ll see companies where, you know, they’re in dreadful financial shape losing money, yet I see their stock price go up in the short term. So as far as I’m concerned, I consider it in an exit situation, a selling opportunity to get out, because ultimately long term the stock and the company value will be at parity to some extent. So, why is the price/earnings ratio an important feature?

Because here we look at the relationship between the price of the stock and the earnings or net earnings of the company, and we do so on a per share basis. In other words, if you see a company, for example, as a million shares of stock and, and the stock price is, let’s say, $10 a share just to keep it simple. We know that the market value of the company is $10 million. But the price per share is $10. Now, let’s say this company makes a million dollars in net earnings. In other words, maybe it had $8 million in total sales and got $7 million in total expenses. So therefore, its net income is one million dollars. So here comes an easy example. If you’re talking about a million shares, at $10 a share, and you’re talking about a million dollars net profit for the company. Now you know that on a per share basis, the stock is $10 per share. And on a per share basis, the earning of the company is $1 earnings per share. So now you have a P/E ratio of 10. And that is, of course, a very low P/E ratio, but a very desirable ratio. And it’s not typical of companies that were in a bear market where the stock market has fallen tremendously, but the company still has tangible value in earnings. So the price has come down.

Now, here’s what you start to think about. Let’s give you some parameters. What is generally a good price/earnings ratio? Well, by and large, a price/earnings ratio of less than 25 is desirable, because of how much you are willing to pay for the company; sometimes you’ll see companies out there with a price/earnings ratio of, you know, 50, 75, or 100; these are much higher; this means that you’re paying more and more for the company for its net earnings. So now you start seeing the risks involved, the higher the P/E ratio, the greater the risk; there’s a greater chance that this might pull back, or the stock price may decline, in event of economic conditions changing and so forth. So for the sake of safety, and from a value-oriented approach, you want to be able to buy the stock of a company where the company has growing sales and earnings year in year out. But it has a fair valuation. Now I give you a minimum of 25. But again, you might talk to 10 different analysts; someone will tell you that under 50 is good. Still others might have a more stringent idea and say no, which should be 15 or less. But I think you get the point: if you had to choose between two companies, and these two companies were in the same industry, both profitable. And all things considered, they were generally equal as companies, but one had a very high stock price and the other one had a low stock price. And I mean, from a point of view of a price/earnings ratio, you’ll find out that a price/earnings ratio, say, 25 is a much more fair valuation; you know what you’re paying for those earnings of the company. Basically, if the P/E ratio was, say, 200, there would be an issue. And typically, when you want to find out when stock market bubbles occur, P/E ratios go through the roof, where the price of the stock is in nosebleed territory much higher, where the earnings haven’t changed that much, or they certainly haven’t moved in conjunction with the stock price involved. So P/E ratios are very important. Now, take a look at the P/E ratio of a company that’s losing money: let’s say, for example, that the stock price of that company is $50 a share, but the company is losing money. Well, now you’ll tend to see that it has no P/E ratio or those financial websites who might calculate it will show a negative P/E ratio. Well, here’s the thing: if you are looking to invest in a company, and the stock of the company either doesn’t have a P/E ratio or it has a negative P/E ratio—in other words, it’s running the losses—well now you’re not investing. This should be a red flag, maybe one of the biggest red flags out there, that you should be aware of. And so the P/E ratio is something I will be very aware of, because as a value investor, you want to be able to pay in accordingly. And make sure you’re not bargaining, but certainly you’re not getting so overpriced; over-priced stock, compared to a company, runs the greater risk in the event of a correction or a downturn or other shock to the financial system. These companies stand to lose a lot in their share value, and you want to be able to avoid that. So you should definitely be looking at the P/E ratio, and make sure that you know, especially if these are bad economic times, the P/E ratio should be low … preferably at or below 25. You can find low P/E ratios typically among more stable, reliable companies out there, like food and water than utilities as examples. There’s nothing wrong with higher P/E ratios. Generally speaking, growth stocks tend to have a higher P/E ratio. And the reason is that many people will be buying the stock with the full expectations (or hope?) that the earnings will come; maybe they’re investing in a company. They feel like this is a hot new technology or hot new service, or the product or service is in vogue right now. And everybody loves it, as there is opportunity for expanding sales and profits, in the near future, and hopefully for the extended future. So, there’s nothing wrong with that. But my feeling is that if you’re paying excessive amounts like say north of a P/E ratio of 100 now, you have to worry; there is a chance that when the reality does hit, the stock price has an even shot of coming down very much so. This is why whenever I look at someone’s portfolio with them, and I see some very high P/E ratio stock or stocks that want to get away with losses, one of the first things I tell them to do is: do you really need that stock? Maybe you should consider selling some or most of it; at the very least, why not consider putting in stop loss orders or trailing stops and make them good till cancelled (GTC). That way, you can be able to go into this particular stock with your eyes wide open and discipline things such as stop loss orders or, my favorite type of order, trailing stops.

These are the types of things that will limit the downside without limiting the upside. So the bottom line is look at the P/E ratios and if you are in very high P/E ratio stock, which again is fine, be more cautious about it and put in place disciplined approaches such as trailing stops to continue to maximize the gains, hopefully watching zig-zag upward. But in the meanwhile, make sure you’re protecting against the downside risk and approaching things in a very disciplined way, with your long-term wealth-building plan remaining intact.

Debt-to-Asset Ratio

This solvency ratio is simple but I check all the time. You obviously want a company with a strong balance sheet where total assets are significantly greater than total liabilities. If a company’s total assets are $2 billion and their total liabilities are $1 billion, then the ratio of debt to assets is 50 percent. If you invest in a company where total liabilities exceed total assets, then you are not investing … you are speculating. Solvency is critical, especially during recessions or bad economic times.

Comparative Year Ratios

This type of ratio is about consistency regarding the company’s primary financial over multiple years. You want a company that shows, for example, growth in net income from year 1 to year 2 and on to year 3. The same should be with total sales and with the company’s net shareholder equity (meaning total assets less total liabilities to derive the company’s net worth or net equity). Successful companies are not about success in a single year: they are about consistently doing well in their key fundamentals year after year.

Growth Versus Income Stocks

When we talk about the classes of stocks that you’re going to invest in, there are many to consider but the main ones that fit your goals, both the short term and the long term, are growth stocks and income stock. Growth stocks are about stocks that are well positioned for steady growth in the coming months and years; in other words you’re looking at capital appreciation or capital gain potential. Income stocks are referred to as stocks that have the potential to give you steady dividend income that can happen now and in the foreseeable future. In this chapter, I cover growth stocks. I will cover dividend stocks (also called “income stocks”) in Chapter 9.

Both of these have a strong purpose in your portfolio and you should be spending a lot of time analyzing these or choosing the advice of financial experts that specialize in these types of securities. In your working years, the focus of your portfolio should be on growth: you want your money growing so that it reaches the point that the total asset value of your portfolio has the ability to be converted to the point that it can give you dividend growth so that you can benefit from dividend income that will rise especially in times of inflation which can be a significant risk for retirees.

How to Choose a Growth Stock

If you see the views of 100 stock-picking geniuses, you could easily get 10 different ideas about how to choose that “hot stock” with blistering growth potential. Just keep in mind that a huge part of the picture is outside your view: there is no crystal ball or sure-fire way to choose a “hot stock” since we must understand the fundamental reason why a stock rises or falls.

When there are more buyers (or buying transactions) for a given stock, supply and demand will push the stock price upward. The reverse is also true … when there are more sellers than buyers, the stock price will fall. This market dynamic is in play every day that the stock market is open for trading.

You can choose the stock of a great company and its price could go nowhere in the near term or even decline. You could choose the stock of a poorly run company and see the stock price irrationally shoot upward. You can’t avoid the fact that the stock’s rise or fall is based on factors that may seem uncontrollable or unforeseeable which is the machination of the marketplace. Given that reality, how do you actually choose a stock with winning potential?

The most important consideration when choosing a growth stock is that the underlying company has strong fundamentals and is a recognized leader in a growing industry or sector.

The best way to proceed with choosing that potential growth stock is to view the knowable factors tied to that stock (analyzing the company itself) and how well positioned it is in a sector or industry that is in demand now and logically in the foreseeable future.

Growth Strategies With Dividend Stocks

One of my favorite strategies for long-term growth is to take advantage of those public companies that have the above features I just covered and also a DRP which many dividend stocks have. To qualify for that company’s DRP it is a simple criteria: you have to be a stockholder of record, meaning that you own one or more shares of the company’s stock. Whether you have one share or 1,000, I think that enrolling in that public company’s DRP should be a strong consideration. The main reason is that you can more quickly compound and grow your stock holdings which will grow your share total to the point that you will have a great potential dividend income in your later years when you cease reinvesting the dividends and change to receiving your income to cover the costs of being retired.

Most DRPs have two valuable features:

I think that DRPs are an excellent (and relatively conservative) way to grow your stock holdings in a given public company. Imagine starting at, say, 100 shares and over time through reinvestment and small periodic cash contributions it will result in having 500 shares giving you a fatter dividend (most dividend-paying companies tend to regularly increase their dividend pay-outs over time).

Insider Stock Strategies

As a corporate executive you can buy the stock of your own company (if it’s a public company) and for most executives this is the best place to start in the world of stock investing. When you are an insider, you have a bird’s eye view into the operations of the company and its prospects. If the company is doing well, then it makes sense to consider buying some of it, given your ability to understand it more intimately than the general public. Just make sure you discuss with the company’s legal department regarding any responsibilities you have about insider reporting. Secondly, remember to diversify. I knew one executive that had over $1 million worth of his company’s stock and little else at the time of his retirement. That is too concentrated and can become a financial hazard if anything goes wrong with the company. Discuss this with your financial adviser regarding appropriate diversification.

Tactics for Safety

Successful stock investing is not just what you buy and when you buy the stock; it is also about how you do it. Check out with your broker’s customer service department or their website about getting proficient about brokerage orders that add safety and discipline to your investing approach such as:

Main Takeaway Points

Stock Investing Resources