How to find growth in barren markets – MoneyWeek

Thefactisthatsomestockscandelivergrowthevenwhenthemacro-economicbackdropisappalling。

AsMorganStanley’sRonanCarrnotes,inthe1960sand1970s,aniftyfiftybandofgrowthstocksoutperformedthekeyUSindex,theSP500,by15%ayearforaperiodofeightyears。

Thewidermarketessentiallywentnowhereoverthesametimeframe。

Betterstill,thesestocksdeliveredevenduringtheworstbearmarketofthattime。

Soreliablewerethesestocksthattheybecameknownas“one-decisionstocks”–oncebought,theywerenevertobesold。

Ofcourse,asanycontrarianworththeirsaltknows,whenyouhearstocksoranyotherassetdescribedinsuchlovingterms,itmeansinvestorsaregettingcarriedaway。

Soitproved。

Thebigcrashfortheniftyfiftycameinthemid-1970s,butnotbeforepriceshadbeendrivenuptothepointwherethesecompaniesweretradingonacollectiveaverageprice/earnings(p/e)ratioof45timesandanaverageprice-to-bookofovereighttimes。

Thenextlessonforinvestorsonwhennottobuygrowthstockscame20yearslater。

Thetechnologyboomofthelate1990ssawwildprojectionsaboundaboutthefuturegrowthratesandeventualsizeofthemarket。

Investors,excitedaboutthepotentialoftheinternet,piledintofirmsonthestrengthofgrowingsalesalone,orevenjustpotentialsalesmeasuredaseyeballsorclicksonapage。

Unbridledeuphoriadrovep/eratiosontheNasdaq,theUStechnologyindex,past50,then100,thenbeyond。

Ahugebubbleformed,whichdestroyedmanyinvestors’portfolioswhenitpopped。

Sowhatcantoday’sgrowthstockpickerslearnfromthemayhemofthe1970sandthe1990s?

Herearefourlessonstoheed。

Growthmustbeconsistent

Flash-in-the-pangrowthisboundtoendintearsunlessyougetyourtimingspotonintermsofbuyingandsellingastock。

Sothefirstcharacteristicofadecentgrowthstockisasolidtrackrecordofgrowth。

Salesarenotenough–anyonecansell£10notesfor£9andachievesales。

Youneedtoseeconsistentearningspershare(EPS)growth。

MorganStanley’sCarrlooksforatrackrecordofearningsgrowthoverthelastfivetotenyears,basedon“theaveragequarterlychangeinearningsforecasts,thevolatilityofthoseestimatechangesandtheconsistencywithwhichearningschangesarepositive”。

Projectionsmustberealistic

Peopleandcompaniesoftenmakedaftpredictions,mainlybyextrapolatinganexistingtrendintothefarfuture。

Forexample,whenIwasjobhuntinginthelate1980s,onelargeaccountancyfirm’sforecastsoftheirgraduaterecruitmentgrowthsuggestedthatwithintenyearstheywouldbeemployingtheentiregraduateoutputofBritain。

Thatclearlywasn’tgoingtohappen,andindeeditdidn’t。

Totakeanotherexample,afewUSbankshaverecentlysuggestedtheywillgrowannualearningsbyanywherebetween15%-20%compound。

Again,thisisunrealistic–atthatratethey’dprettysoonoutgrowtheentiremarket。

Soacompanyneedstohaveroomtogrow。

Onethingtolookforissignsofmarketsaturation。

InBritain,forexample,theCompetitionCommissioncanstopafirmfromtakingoveranotherwhenitssizemakesitanti-competitive。

Atthatpointoverseasgrowthisusuallythenexttarget。

Butthiscanbemuchhardertoachieve,asretailinggiantsTescoandMarksSpencerbothdiscoveredaftersomeill-fatedforaysintotheUSmarket。

Onlypayafairpriceforgrowth

AstheMotleyFool’sDavidKuopointsout,there’sarightpriceforeverything,andthatincludesgrowthstocks。

Investorsinthe‘niftyfifty’andthedotcombubblelearnedthehardwaythatyoumustn’toverpayforgrowth。

Thegoodnewsfortoday’sgrowth-seekersisthatmanyotherinvestorsarefixatedonsafety,sosomegrowthstockstradeoncompellingvaluationmultiples。

I’dsuggesttwotestsasaminimum。

Kuosteersclearofanythingwith“toorichap/eratio”。

Onewaytotestthisisviatheprice-to-earnings-growth(PEG)ratio。

Itcomparesthep/eratiototheexpectedrateofearningspersharegrowth。

Theidealissomethingbelow,ornotfarfromone。

Ahighmultipleisaredflagthatgrowthisbeingoverpriced。

Don’tbuyaweakling

Carrpointsoutthatinatoughpatchfortheglobaleconomy,evengrowthstocksneedtohavedefensivecharacteristics。

Aquicktestthattheyaregeneratingconsistentcashflowisadividendyieldof,ideally,3%orabove,consistentdividendgrowth,andalowpayoutratio(theproportionofannualearningspaidoutasadividend)。

Afinal,goodtestforbalancesheetstrengthisaPiotroskiscoreofsevenorhigher。

Thislooksatninemeasuresoffinancialstrengthwithfirmsscoringonepointpertestpassed。

UsingCarr’sscreen,thetop-scoringsectorsareautomobiles,materialsandenergy。

Ofthese,we’dfavouroilgiantShell(LSE:RDSB),asitislessexposedtoaslowdowninChinathantheautomobileormaterialindustries。

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