In my last column, we examined the nature of true growth stocks and of growth stock investing. This week, we look at the guidelines for investing in shares that resemble true growth stocks.
I broaden the classification simply because there is money to be made from shares that grow faster because they are swept up in a growing market and not necessarily because they match the pure definition of a growth company (that is, a company that is able to create its own market and provide products that are distinctive in the eyes of the market).
Let me start with a confession. I have always found this type of investing really difficult because, first, you need to be an arch optimist and second, for quite some time, you need to buy into growing market consensus. I may generally have a positive outlook on a good day, but buying into consensus is difficult when your natural investment style is to fish in lesser charted waters.
However, I have found these guidelines useful, in addition to leaving some of my money with a good growth stock manager. Those who are honest with themselves call in the experts when necessary!
A lesson from nature when investing in growth situations: There are three phases to growth in nature and in business. These are growth, maturity and decadence. Smart management teams may lead the company back into growth with new ideas as older ones mature, but in general most growth stocks face the risk of maturity and decadence. And it is seldom a smooth transition. It is not as if investors say, "Hey I see ABC is getting a bit mature. It's OK, I'll be happy with 10 percent a year from now on. It was great to get 30 percent a year up to now, but I'll just stick with the share". Growth stocks that smell of maturity are dropped faster than an aging soap opera actress who refuses plastic surgery.
Here are some guidelines when investing in growth stocks:
- Make sure you understand why the company has grown so fast and is expected to do so in future. It could be from general economic growth, growth in its sector, or preferably because of the company's superior product and marketing innovation, as well as its use of technology.
- Beware of the super-high growers (50 percent plus) as that level of growth tends to take place in very hot industries and is not that sustainable.
- Make sure there is still room to grow, either geographically or by taking more market share, or by adding on products.
- Make sure the balance sheet is solid. In particular, you should always watch the cash flow, even when everyone tells you it does not matter. Cash flow always matters in the end with growth companies.
- Look at the rate of growth. It is better to buy when the rate of growth is still accelerating.
- Once everyone owns it and knows about it and it is in the top 10 holdings of most unit trusts, rather find a new idea. Practically, I have found this to be the most compelling reason to sell, and I would rather sell a growth stock too early than too late.
- The rule of thumb is to buy these shares at price:earnings (p:e) ratios that are around the growth rate, but during market cycles when growth stocks become popular, the p:e ratio can stay higher for a lot longer.
Remember that most people are less than truthful about how much money they have made out of the highest-performing shares of last year. Don't feel too left out and stick to your own principles. As long as your financial goals are fulfilled, you should not feel bad if you sell a growth stock a little early.