When Hunting for Growth Stocks, Focus on Factors that Count

 

Many years ago, Carlton Lutts, our founder and a great student of the market, told us a brief growth stock investing tale from many decades ago: 

An analyst was asked by his boss for a report on Boeing (BA) because clients wanted to know more about the company. The analyst responded, “No problem. Do you want a bullish report or a bearish report?”

The point was that, at any given time, you can find both positive factors and negative factors on any stock. And often these plusses and minuses are two sides of the same coin—a stock might be strong, indicating accumulation … or the stock is overbought and overvalued. Or the stock might have a low valuation, but that could mean investors believe business will remain sluggish. 

That’s why it’s key to stay focused on factors that have the highest correlation with good stock performance while generally ignoring all the others. For a growth stock methodology, that means having a big story (including barriers to competition, mass market, revolutionary new product or service), excellent current and future sales and earnings growth (at least 15% to 20%, and ideally much more) and a bullish chart (with big-volume clues and a strong Relative Performance line). 

Having most of these factors doesn’t guarantee success, which is why we use loss limits and don’t put all our eggs in one basket. But it’s a far better plan than focusing on things that have no record of helping you find good growth stocks (or avoid bad ones).

Such unproven factors include:

-Insider selling: Nearly every big winning stock in history had insider selling on the way up, but it’s usually not a red flag. Employees may be simply selling to cash in (often after working at the company for years when it was privately held) and to diversify their wealth, as opposed to an imminent fall in the business. What really counts is the action of institutional investors, who can gobble up any insider sale in no time.

-Valuation: It’s not meaningless, of course, but many of history’s biggest winners got going with huge valuations. When we bought Apple (AAPL) back in mid-2004, it had a P/E ratio of 40. Baidu (BIDU) had a P/E ratio of 56 in July 2009 when we bought in. And First Solar (FSLR) was recommended in April 2007 with a P/E north of 200! All of them went on to huge gains. The bottom line is that, if the growth is exciting enough (and the market is bullish), valuation doesn’t stand in the way of institutions piling in as the story unfolds.

-Analyst price targets: Many people see a bunch of $80 targets for a $55 stock and conclude the stock is a bargain. But it’s an open secret that most analysts usually “chase” the stock in either direction—if a stock corrects 40% over a few months, you’ll usually see a bunch of analysts cut their targets and downgrade their rating. And vice versa. The bottom line is that these price targets are guesses based on a valuation formula that they change from time to time.

-Opinion of a well-known investor: We regularly check up on the holdings of a select few growth fund managers to see what they’ve been buying or selling, and we think that’s a good practice for any investor. But any data we get from that provides background information—we don’t buy or sell based on that. So the next time you hear a top manager on TV, listen to what he or she says … but then do your own due diligence before following along.

-Ultra short-term stock action: If the market is up 150 points, and your stock is down two points, it doesn’t necessarily mean it’s in trouble. The market doesn’t always move on your timeframe, so don’t get too caught up in day-to-day moves, especially the market’s.

-Esoteric technical action: We don’t pretend to have the Bible of growth stock investing; whatever works for you is fine by us. But our method of technical analysis doesn’t rely on complicated patterns, wave counts or the alignment of the stars—it’s just simple supply and demand, incorporating trend. Anything beyond that doesn’t help much, at least according to our studies.

We write all of this today because the market is beginning to shape up and, with any luck, we’re starting a new buying spree. When it comes to selecting the best growth stocks, it’s vital to focus like a laser on the handful of factors that have proven that they can point to a new leading stock.

*Note: This article originally appeared in the March 2 issue of Cabot Growth Investor


Michael Cintolo can be found on Google Plus.

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