How to identify high-growth stocks: seven things to look for
09:00, 17 September 2021
The rise of technology and other emerging sectors has triggered the development of an investment methodology known as “growth investing”. This methodology focuses on finding companies that are expanding their businesses at an incredibly fast pace.
For those who have successfully adopted this methodology, returns have been quite attractive in the past few decades as companies like Amazon (AMZN), Netflix (NFLX) and Shopify (SHOP) have multiplied their valuations by more than 100x in relatively short periods.
The question, however, would be: how can one identify top growth stocks? Let’s summarise some key characteristics the fastest-growing stocks share to help you identify potential multibaggers – equity stocks that give a return of more than 100%.
How to identify high-growth stocks? Key features to watch
Huge problem, practical solution
One important characteristic of top growth companies is that they sell solutions to problems that are considered relevant to their target audiences.
Think of Google. Before this search engine existed, finding things on the internet was quite difficult, and you typically came across irrelevant and often unwanted content in the process. Google solved that problem by introducing a solution that we all use and rely on today: a single-field search engine that prioritises results based on their relevance.
Total addressable market (TAM)
The total addressable market (TAM) of a company can be expressed in multiple ways. However, the best way to look at it is in relation to how much consumers will spend every year in total on a product, service or solution that is similar to that which the company is bringing to the market.
Most publicly traded companies share their TAM estimations on their investor’s materials, or alternatively, this figure can also be found in the business’s initial public offering (IPO) filings.
One thing to keep in mind is that TAM estimations should be rational. For example, a start-up can’t claim a global TAM as it could take the business decades to reach such a large market. Instead, it is better to estimate its TAM based on the immediately addressable market for the business within the next five years.
Revenue growth
The highest growth shares have usually been able to expand their top-line results at a pace that exceeds the industry average by a long shot.
Here, Tesla provides a good example. While vehicle manufacturers such as General Motors have seen their sales decline over the past years – moving from $140.2bn in 2016 to $108.6bn last year – Tesla managed to grow its top-line results from $7bn to $31.5bn during the same period.
The reason why sales of top-growth stocks tend to expand at a faster rate compared to their peers is that they have typically found a way to disrupt the market by introducing a new product or a new process, or simply by tapping a previously unserved segment or market niche.
That said, past growth is not as important as future growth. In this regard, the best growth stocks are typically those that still have significant potential ahead, based on a largely unserved TAM and a relatively low – but progressively expanding – market share.
Profit margins
Even though their growth margins can be narrow during the early stages, the best growth stocks manage to expand their profit margins progressively every year, and typically display an elevated gross profit margin.
A high gross-profit margin guarantees that once significant business volumes are reached, the company will be more than able to translate its higher sales into elevated bottom-line profits as well.
Moreover, steadily expanding profit margins will contribute to increasing trading multiples over time for the company, thus resulting in a higher market capitalisation.
Manageable debt
Companies that are growing will also need capital to continue expanding. Therefore, it is perfectly understandable that the top growing businesses will have to raise money every now and then to keep building their core business with further investment.
However, obtaining these funds through debt is not usually a good idea for a growing company unless that debt produces either low-interest or no interest expenses. In most cases, publicly traded growth companies issue convertible debt notes.
These instruments can be exchanged by the holders of a certain number of common shares in the future. In exchange, lenders typically demand a lower interest rate compared to that offered by traditional bonds.
Management
A management team with a strong background in the industry in which the business participates is another characteristic of fast-growing stocks. The reason for this is that the founders have usually come across the problem they are attempting to solve while providing their professional services to other businesses, which means they are now becoming increasingly familiar with the industry’s practices and issues.
This background also helps managers in becoming one step (or many) ahead in the learning curve compared to other founders who have no prior experience in the industry.
One can also dig deeper into the management team’s achievements during their tenures at other companies to assess their competence.
Past performance and future prospects
Some investors could think that past performance is an important factor when deciding to choose growth stocks. However, positive past performance does not always necessarily translate into future growth.
In this regard, even though past performance can be a great indication that a business has done well, its future prospects are more important, as you will be investing in what develops next, not in what has happened in the past.
These are a few elements that matter more than past performance for top growing businesses:
A relatively large and unserved total addressable market (TAM)
New products and services being developed, with plans of being launched soon
New markets the company can still tap into
The introduction of new processes that have the potential to increase profit margins over time.
A few comments about the valuation of growth stocks
Since most of the potential of growth stocks will be realised in the future, past-looking metrics are not as relevant as forward-looking metrics when trying to estimate the intrinsic or fair value of the business.
In this regard, instead of relying on the traditional price/earnings (P/E), P/B ratio, and EV/EBITDA metrics when assessing growth companies, some alternative valuation methods have to be used.
One way to value growth stocks is to estimate how much of their total addressable market (TAM) they can effectively tap into within the next five years. This would help facilitate the process of estimating how much the business can produce in terms of revenue by then.
If the current market price is still relatively conservative compared to the company’s growth potential in the next five to 10 years, then the stock would be considered attractive to a buy-and-hold investor.
In any case, investing for growth demands some degree of creativity when establishing the fair value of a company, as forward-looking estimates for operational metrics will tend to be more relevant than past-looking financial multiples.
Common ‘traps’ when looking for top growth stocks
Serial acquirers
Companies that are growing only through acquiring other businesses are typically dangerous bets. It is often difficult to integrate new companies quickly and to realise the synergies managers tend to propose when they promote these deals.
Moreover, businesses are typically acquired at a premium of their intrinsic value, and that tends to reduce the return on investment for the company before any money is made.
One-off growers
Some companies can grow during a limited period due to external factors. One recent example of this would be Clorox, a company that saw its sales skyrocket during the pandemic amid increased demand for its sanitisation line.
Moving forward, the kind of growth that Clorox saw during the health crisis might not be replicated due to the absence of this catalyst. Notably, Clorox stocks have since plummeted in the aftermath of the pandemic, with shares currently down to $170.02 from a 52-week high of $226.38.
Where to find growth stocks?
Now that we have outlined some factors that can help you evaluate stocks with the highest growth potential, you might be asking how you can spot them.
One way to do this is to find the best-performing stocks of the past quarters by using a stock screener. Stock screeners are tools that help traders and investors to filter stocks depending on certain criteria and user-defined metrics.
Another way is to read trade magazines covering up-and-coming industries. At the moment, some promising segments of the economy are artificial intelligence (AI), education technology (EdTech), remote work and gaming. Some articles may help you identify niche companies that are still relatively small and unknown to most market participants.
Finally, there are some financial magazines and online publications– the Wall Street Journal, Financial Times, Forbes – that regularly publish lists of promising businesses. Some of these companies may display the characteristics mentioned above to qualify as stocks for future growth.
Bottom line
How to look for growth stocks? Keep in mind that even though you may find some great candidates for your portfolio of growth stocks, you will probably need to have some patience for the market in order to fully acknowledge the potential you are seeing now.
Companies that have grown to become 10-baggers (an investment that returns 10 times its initial purchase price) have often traded range-bound for years before their valuation suddenly skyrocketed once the market catches up with their performance.
Edited by Alexandra Pankratyeva
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