Two investment strategies are popular (in fact, so popular that everyone seems to have heard of them): buying undervalued stocks and buying growth stocks. In this post, we’re going to cover growth stocks. These kinds of stocks typically are priced at a premium, because the investors who are holding on to them generally believe that they’re going to keep growing. Like anything in the stock market, buying a growth stock is a zero sum game. The guy that’s selling stock to you is betting that the price is going down, and you’re betting that the price is going to go up. So one of you must be wrong. Here’s how to tell if your stocks is still a growth stock.

Strong, safe, “margin-of-safety” growth.Stock

Finding strong growth is the easiest part. Just look at the earnings per share! However, just looking at earnings per share doesn’t account for the whole picture. In this current recession, many companies are making more and more money. HOWEVER, they’re making more money by constantly cutting costs, not by expanding business. This is not a good sign for a growth stock.

Growth created by beating competitors is better than growth created by corporate acquisitions. 1 in 10 mergers/acquisitions work out. While the intended goal of acquiring a company is “synergy” (1+1=3), in often cases, 1+1=1.5, which boggs down the parent company with many problems.

Also, strong and safe growth stocks have an “edge”. It’s hard for competitors to dislodge them because in a sense, they have a monopoly. Take Windows or Facebook for example. Unless the entire PC market vanishes, no one is capable of beating Windows, because they own the whole damn OS! Facebook has what is called a “network effect” where the power of Facebook increases exponentially with each new member. Facebook members aren’t going to switch to a new social network because their friends are on Facebook.

Cheap growth.

Take a look at the company’s return on invested money (which can be found on most financial sites like Yahoo or CNBC). A good growth stock will have a high “return on investment”. A low return on investment is dangerous; the instant that wafer thin margin is wiped out, the company will face a massive amount of red ink. On the other hand, a high return on investment is favourable: it means that if consumer spending declines or the company’s costs suddenly spike, the company will still make profit.

What industry is your the growth stock in?

One thing I find to be ridiculously stupid is when people say “oh, Google is so cheap. Just look at their P/E ratio” (it’s currently at 14x earnings). What they fail to realize is that Google is a tech company. While companies like Coca-Cola (which was a growth stock in the 80s and 90s) can be run by ham sandwiches, tech companies can’t! The average life of a tech company is no more than a decade, so attempting to project the tech stock’s earnings into the future is futile! The darling of the industry today may well be sh** the next!

In short, tech stocks fly high and can crash and burn. Companies in other industries may take longer to grow, but also longer to falter.

Size becomes a constraint.

A key factor to whether or not a company is still a growth stock is “how big is it’s market capitalization”? As we all know, at a certain point, size becomes a huge restraint. Take a look at Apple. It’ll be much harder for them to reach a trillion dollar valuation than it took them to go from a $20 billion to $40 billion valuation. Same goes for investing. Making a 30% return on a billion dollars is much harder than making a 30% return on a million dollars.

Mullins | mullins@siaaopportunity.com

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