- Growth stocks can multiply your returns
- Look for companies with sales & profits growing fast and steadily
- Consider if there is room to grow in the market
How can you tell if a growth stock will be a good investment? There are several factors that will help you identify which stocks to buy and which stocks to avoid.
Is the Company Growing Fast and Steadily?
By definition, a growth stock is a company that is growing fast financially (sales and profits). There is no exact definition for how fast a company must be growing to qualify as a growth stock. This type of stock is good to own, because it can have a huge payoff. In just a few years, a growth company can provide returns of 3 times, 5 times, even 10+ times your investment.
For example, for the six years from August 2009 to August 2015, these stocks offered the following returns:
|Priceline (NASDAQ:PCLN)||9.7 times|
|Salesforce (NYSE:CRM)||5.4 times|
|Apple (NASDAQ:AAPL)||4.5 times|
|Netflix (NASDAQ:NFLX)||18.5 times|
|Amazon (NASDAQ:AMZN)||6.3 times|
|Facebook (NASDAQ:FB)||2.4 times (past 3.5 years -- since IPO in May 2012)|
The ideal growth company will have a steady increase in sales, profits, and preferably improving margins year after year. Steady improvements in these areas give investors confidence -- investors hate uncertainty. Steady improvements are much better than erratic sales and profits, big increases in sales and profits followed by big decreases -- the kind of volatility that can give investors an ulcer.
Sometimes companies will increase spending on research & development, market penetration, or other activities that lower profits now to increase profits later. An example might be a company spending extra on marketing efforts to gain market share from a competitor. In this situation, sales continue to increase while profits fall or even go negative. At this point, you need to know that the strategies the company is pursuing could lead to higher profits later (a good thing) or if the company has constantly increased selling and administrative costs that will permanently cut into profits (not good). A highly profitable and fast-growing company that chooses to invest is very different from a company that never was profitable in spite of fast-growing sales. In the end, only profits matter. Many companies are no longer in business that fit the latter description, reminiscent of internet companies in 2000 that never showed a profit.
Determining if the stock remains a good investment requires research on the company's efforts. Is the company finding success in their early efforts? Is their spending in line with the company's current business? (If they are pursuing a completely new industry, that's a bad sign) How do they compare vs. the competition? Is the drug a pharmaceutical company is researching have a large enough market to be profitable?
Buy the stock where the company's rate of growth is speeding up or remaining steady. If so, the stock price will continue climbing at a fast pace. If the rate of growth slows down, investors fear the days of fast growth may be permanently at an end, and the stock price will fall hard. A good example of this is when Netflix made some mistakes in 2011, hundreds of thousands of subscribers cancelled the service, and the stock price fell from $42 to $10 within six months.
Does the Company have Room to Grow?
Being in an emerging sector or industry is a good thing, but there needs to be plenty of market left to capture. Has the market already been filled up by a big competitor or is there room to grow?
At some point, every company that is large now was once small and grew quickly. The small company grew into a large company and there is limited market left to capture. When that happens, there are limits to how much more of the market it can capture and growth rate slows.
For example, Microsoft, a fantastic growth company in the 1990's, is now a large, mature company in a slowing industry -- the pc market. Microsoft stock that went up like a rocket now moves up slowly.
Does the Company have a Natural Monopoly?
Certain types of companies have natural monopolies, which makes them both profitable and hard to compete with. Microsoft made a lot of money creating operating systems and software. They weren't the only company that could do that, but they became the standard used in the pc market. Any makers of software have a monopoly on their software. Others can make software, but if you are first and create a strong product, then you become the standard. It's hard to dethrone an established king.
The Keys to Determining a Good Growth Stock
The keys to knowing if a stock is still a growth stock and worth investing in, is:
- Knowing if there is more market left to capture
- Monitoring the company's growth rate in sales & profits
- Seeing that profit margins are climbing or remaining steady
- The company has a natural monopoly
Top 5 Tech Growth Stocks
With these factors in mind, here are the Top 5 tech growth stocks, counting down:
Netflix has recovered from missteps made in 2011 regarding pricing and requiring two separate bills. They have made a key insight with the original hit series, House of Cards -- Why pay others for content when you can create at least some of it yourself? You can be sure that Netflix will be creating more original content in the future. Although Netflix has an excellent long-term outlook, keeping up its recent fast growth may be difficult -- it was partly based on wooing back lost subscribers.
Note: You might also be interested in Netflix Stock Analysis Video.
Linked In (NYSE:LNKD)
LinkedIn's (NYSE:LNKD) revenue has increased by 45-55% annually in recent years. Although profits have been volatile, going from positive to negative and back again, the company has a user base of over 380 million worldwide. My impression is that they have not fully discovered all the ways they can bring in revenue from their platform. Expect better performance from the company in the future.
Also see: LinkedIn Stock Analysis Video evaluating the company fundamentals.
Apple has a loyal user base and a strong history of well-designed smart phones and other communications products. No one can predict consumer preferences like Steve Jobs, but the framework for excellence he set up is still in place. Expect Apple to continue making popular and innovative products that will fly off the shelves.
Also see: Apple stock analysis video evaluating the company fundamentals.
Priceline has experienced consistently fast growth for years. They are the #1 travel company globally with plenty of room to grow in new markets. The stock price reflects their strong performance, climbing from $335 to $1250 in the past 5 years.
Note: You might also be interested in Priceline Stock Analysis Video.
Like Priceline.com, Facebook has high margins and low costs for continued growth. About 20% of the population of the planet uses Facebook to communicate with family, friends, and to conduct business. As of the 2nd quarter of 2015, the company had 1.49 billion active monthly users -- a statistic that has been steadily growing for years (see graphic below). Facebook has been on a strong upward trajectory ever since proving they could capture mobile ad revenue in 2013. Sales and profits have been growing at a fast rate ever since. They only have 80% of the world's population left to capture.
Also see: Facebook Stock analysis video looking into the company fundamentals.
Number of Facebook users, in millions (as of the 2nd quarter, 2015)