The market’s upside action this week, in the wake of the Fed’s interest rate cut, has been unusually bullish by many technical measures. But I’m not going to write about that today. I’ll leave that to ace technical analyst Mike Cintolo, who weighs in on Monday. Until then, suffice it to say that you should be heavily invested now.
But invested in what?
Great growth stocks.
I’m a growth stock investor at heart, in part because my father was (and is) a growth stock investor at heart, so today I’m going to focus on six fundamental characteristics of great growth stocks.
These aren’t just any six characteristics. These are the six fundamental characteristics that correlated most highly with profits in a ten-year study of stocks bought for the Model Portfolio of the Cabot Market Letter.
In other words, after ten years of investing (1997 - 2006) these are the factors that were best at bringing us profits. Might another ten years bring a different result? I’ll let you know in ten years. Until then, however, I feel pretty good about these.
So here they are, with the very best criteria - in the time-honored tradition of lists - coming last.
#6 Huge mass markets — This one is well known to many investors. The more potential customers there are for a product or service, the greater the possibility that the business will be a success and the greater the possibility the investment will be a success. But how big is a mass market? Sometimes it’s hard to know where to draw the line; there is no right answer. Choosing between a manufacturer of curling equipment (that sport where they slide the rock down the ice) and a manufacturer of shoes, I’d go with the shoe manufacturer. Its mass market was just one reason we added Crocs (CROX), the maker of “funny-looking plastic shoes” to Cabot Market Letter’s Model Portfolio nearly a year ago.
#5 Market dominance/barriers to entry - Patents often provide a great barrier to entry. And if there’s no one else providing competition, you can be sure those patents are strong. Intuitive Surgical (ISRG), for example, has been a great winner, partly because it has no competitors. As for market dominance, this can be harder to measure. GameStop (GME), for example, is by far the biggest retailer of video games in the U.S. But with just 23% of the market, is it dominant? Intelligent minds can disagree.
#4 Accelerating earnings growth - There’s no ambiguity here. If a company’s earnings growth rate (measured by comparing the earnings of one quarter to the earnings of the same quarter in the prior year) increases for two quarters in a row, growth is accelerating. In general, faster growth is better growth, and a company whose earnings growth rate is accelerating (whether it’s due to increased revenues or more efficient operations) is becoming an increasingly attractive investment. My perception is that acceleration tends to be underappreciated by investors (some just don’t see it), so buying when you first recognize it usually works out very well.
#3 Triple-digit revenue growth - In my experience, companies growing revenues at triple-digit rates (100% or better) tend to be small and less well known; thus they’re ripe for buying by institutions as they grow. Almost all solar power companies were enjoying triple-digit revenue growth (100% of better) earlier this year when their stocks were hot … and most still are. When Google came public it was growing at a rate of 125%, now it’s slowed to 58%, while Chinese Baidu (BIDU), which is hitting new highs, is growing at 120%. Crocs (CROX) is growing at 162%. Wynn Resorts (WYNN) is growing at 152%.
And little China Security & Surveillance Technology (CSCT), which I’ve mentioned here before and which had a nice jump last week, is growing at a rate of 550%!
#2 High profit margins - Software companies tend to have very high margins because they deal in code that costs nothing to ship or store, while iron ore companies tend to have very low margins. In recent decades, high-margin stocks have trounced low-margin stocks. But with the recent strength of companies dealing in steel, potash, coal and other bulk commodities, the times may be changing. Jim Rogers, who for years has been trumpeting the new global bull market in commodities, certainly thinks so.
#1 Excellent, innovative management - Henry Ford, Thomas Watson, Ray Kroc, Jack Welch, Walt Disney, Akio Morita, Sam Walton, Bill Gates, Larry Ellison, Steve Jobs, Meg Whitman, Jeff Bezos, Martha Stewart, Craig Venter and Dennis Kozlowski (for a while) were (and are) all great managers who led their companies to success by thinking differently. Admittedly, there is no hard and fast measurement of management talent, but because this is the most important characteristic of all - and I think it always will be - it’s worth thinking about very hard. Most managers are nowhere near as good as those legends. But when you find a top manager - especially one with a record of prior successes - you should give him or her a little extra leeway. Top managers have a way of overcoming obstacles through a combination of vision, enthusiasm and leadership.
Interestingly, several criteria that had been favorites of ours before this ten-year study proved to have a far poorer record of finding winners, so we weight them much more lightly now.
We used to think low debt was good; turns out it didn’t matter much.
We used to think high recurring income (think razor blades for Gillette or film for Kodak) was a good thing. Well, it may be so for conservative companies later in their growth cycles, but it didn’t improve our success rate.
And finally, we used to favor small companies over large ones, simply because small companies can grow faster. But among the stocks we bought, we had more success with large ones! The reason: the volatility inherent in smaller stocks knocked us out more frequently.
In sum, my advice to investors working to grow their wealth by investing in growth stocks is to weigh those six criteria above heavily. If you keep them in mind as you go about evaluating companies - perhaps write them on your arm the same way my 15-year-old son writes his homework assignments - I guarantee that you’ll be able to identify great growth companies more easily, and you’ll be able to dismiss lower-potential companies faster, too.
But there’s one more important characteristic we look for in a growth stock, and that’s momentum. Momentum (technically, the degree to which a stock is outperforming the market) provides confirmation that other investors are excited about a company’s future, too. It’s such an important factor that we have a whole newsletter, Cabot Top Ten Report, that uses momentum as its primary screening factor. There’s nothing like investing in hot stocks to get your blood boiling; with the rig
The drawback to momentum, however, is that it means buying stocks that have already advanced substantially, which means there’s always the risk of a sharp correction … or worse.
Over the years, the number one request from readers who were averse to such risk has been, “Why don’t you recommend these great stocks sooner?” My answer was always; “Our system doesn’t find them sooner.” Lame, perhaps, but true.
But we have a Cabot publication dedicated to doing just that. The editor of this publication is notable for both his vision (not unlike those great managers listed above) and his dedication to deep research. As a result, he finds companies with great growth potential … and he finds them early.
He found Hansen Natural back when it was selling near 3. It’s now 51.
He found Vasco Data Security in 2004 as well, when it was selling under 2! It’s now 36.
He found Bolt Technology when it was near 4. It’s now 36.
And he’s finding plenty of new companies this year.
Granted, these stocks don’t just stand up and run after he recommends them; they require time to mature, and time to be found by the institutions that ultimately drive them higher.
But if you buy early and hold on tight, these stocks can be major contributors to the performance of your portfolio.
You can read a lot more about this editor and his new publication, Cabot Small-Cap Confidential, in an email I’ll be sending you Saturday.
If you’d like to buy great growth stocks sooner (and cheaper), you owe it to yourself to check it out.
Yours in pursuit of wisdom and wealth,
Cabot Wealth Advisory