A lot of people will tell you that growth stocks are the best companies to buy.
But how do we define “growth?”
Ask the pundit or fund manager just what the hell is a growth stock and watch them stumble for a definition.
Everyone has a different answer.
Some think it’s tied to sales growth. Others will say you need to see a boost in earnings growth.
It looks to me like everyone has a part of the formula for what makes a great growth stock.
But everyone continues to get it wrong.
Well, it’s time to set the record straight.
Some say growth stocks are just companies growing revenues at a very high rate.
That is part of the picture.
I’ve watched a lot of companies “sell themselves” out of business.
What I mean is they sold lots of their products and services, but they did not make enough profit off each sale.
Many young, fast-growing companies have flamed out and died as they failed to convert revenue into profits.
Relying solely on revenue growth will also produce a list of externally managed REITs and asset managers that are issuing stock to buy new assets to create higher “revenue growth” and, of course, higher management fees.
So should we rely on profit growth instead?
That initially sounds reasonable.
However, fast-rising profits without corresponding revenue growth are often a sign of financial engineering or manipulation.
Sometimes it’s a result of a company buying back enormous amounts of stock every year.
While that’s not necessarily bad, I don’t think being a serial stock repurchaser qualifies a company as a great growth stock.
Profit growth well above revenue growth is also a sign of a cyclical company benefiting from rising commodity prices.
That’s fantastic if the commodity price keeps rising, but we are not talking about cyclical opportunities today. I am looking for great growth stocks, and cyclical commodity producers do not fit the definition.
So, let’s turn our attention elsewhere.
Narrowing Our Focus
When I combine high revenue growth and high earnings per share growth, I begin to get closer to uncovering true growth stocks.
When I combine the two factors and screen for well above average sales and earnings growth, I begin to see the names like Amazon (AMZN), Netflix (NFLX), Nvidia (NVDA), Facebook (FB) and Square (SQ) that everyone thinks of as growth leaders appear in the results.
Once we have this universe of potential growth stocks defined, we need to weed out the pretenders and “almost made its” from the list to connect to the core growth universe.
One of the first steps I take to thin the herd is to check on what the Wall Street analysts think will happen over the next several years.
If the consensus view is that the sales and earnings growth rates will decline going forward, then this company is not a true growth stock.
Perhaps it is a maturing company that will move into the next phase of its corporate life as a blue-chip holding or fall to bargain-basement value levels.
It is impossible to tell what lies in the company’s future, but if analyst projections are declining, it is no longer a growth stock.
We also want to take a look at the company’s return on equity.
I want to see a high ROE compared to other companies in similar industries.
I want to see numbers that start high and preferably move higher while I own the stock.
The return on equity tells me how efficiently the company is when it comes to reinvesting its cash.
If the ROE is staying high or moving higher, then management is doing a fantastic job managing their money.
If the ROE is falling, they are likely not doing as great a job with the cash as I want to see.
Finding companies that consistently meet my criteria for growth, analyst expectations, and high returns on equity is how I can uncover the next great growth stocks.
We’re targeting companies that can and will perform like Amazon and Netflix did over the last decade.
Not every stock that meets our criteria for some period of time will be a huge winner, but those that qualify quarter after quarter and year after year as a growth stock can build life-changing wealth for long term investors.
Remember, it’s not just about revenue or profit growth.
You need to see growth in the ROE if you want to tap into the long-term potential of the next generation of great growth stocks.
We’ll dive deeper into this subject in the coming days.