Today I have a guest post from Troy over at MarketHistory.org. Troy blogs about his thoughts on the stock market and investing. He uses the stock market history to rationally predict what the stock market will do in the future. Although my philosophy for investing is to use the keep it simple stupid (KISS) method, I do like to read about the stock market’s trends and that is where I would recommend checking out Troy’s perspective. Now, onto Troy’s post.

There are two main kinds of investing: value investing and growth investing. I consider dividend investing to be a subcategory under value investing because dividend investors want to buy relatively cheap stocks with high dividend yields. Growth stocks tend to have the opposite characteristics of value stocks. They are relatively expensive and have low or nonexistent dividend yields.

The good thing about a long term growth stock – a real winner – is that the stock’s current valuation isn’t very relevant. The stock might have a valuation that’s double of the market’s average, which makes it expensive by today’s standards. But if the company’s earnings grow at a rate of 20% a year, the company’s stock price will rise even more very soon. Valuation isn’t static.

In fact, some studies argue that over the long run a basket of growth stocks will outperform a basket of value stocks!

So how do you spot a relatively new growth stock that still has many years left in the tank?

Look for growing industries

As the saying goes, a rising tide lifts all boats (or most of them at least).

It’s easy to predict which industries will continue to grow because industry cycles last many years if not decades. The internet experienced rapid growth from 1995 – 2010, and only recently has that growth started to slow down. Another example is society’s shift towards healthy dining and away from fast food, which shows no signs of abating. Hence, you don’t really need to predict growth in future industries. You merely need to see what’s happening right now and extrapolate that growth into the future because the current trend will most likely continue for years.

[Grounded Engineer: I agree with this point. However, if you are going to invest in a specific industry, I would recommend investing in many different companies within a given industry to diversify your investment.]

Growth stocks tend to buy back their own shares

A lot of growth stocks in the second half of their rapid-growth phase tend to buy back their own shares. So if you see a company that’s doing a lot of share buybacks, it’s a good sign that the company’s earnings and revenues are growing significantly.

Look for growth stocks that don’t have a lot of cash

Growth stocks are too busy growing the business, expanding revenue sources, and increasing headcount to leave cash just sitting there. They need all the cash they can get to pursue new business opportunities and expand existing ones!

Having lots of cash means that the company doesn’t know where to reinvest its money anymore. In other words, its growth opportunities are limited. These companies tend to be cash cows like Apple who can’t really grow anymore because:

  1. The industry does not have promising prospects or…
  2. The company has already dominated its industry and is too big.
[Grounded Engineer: Excellent point. If the iPhone 8 flops for Apple they could be in big trouble!]

Look at history

Look for a company that has been growing rapidly in the past 3-5 years and make sure that it doesn’t have any strong competitors. Companies experiencing rapid growth without strong competition do not just suddenly see their growth slow down drastically or stop. The rate of growth usually remains steady. Hence, the companies’ current growth rates can be projected a few years into the future.

Look for a stock that has just broken out from resistance AND is leading the market

A stock may be stuck in a big range for many months or years. When the stock finally breaks above the top end of this range (resistance) and is rising FASTER than the broad market (e.g. S&P 500), that usually means there’s something special about this company. Likewise, a stock that has just made a new all-time high is encouraging. It means that big buyers are accumulating the stock in anticipation of significant earnings growth.

Hence a big breakout is an indication that the company’s fundamentals are much stronger than the broad market’s fundamentals and is probably a growth stock.

Keep in mind that a leading stock doesn’t have to be the biggest company in its industry. A lot of small and medium-sized growth stocks can lead broader stock market advances.

A company whose management owns a lot of the shares

Nobody knows more about how well a company will do in the future than management because the executive management team leading the company into the future. If management owns a lot of the shares, it means that the executives believe that the company will grow substantially in the future. If management doesn’t even believe in the future of the company, should you? Probably not.

Look for companies that give employees a lot of stock options.

Growth companies typically give their employees and especially the management team a lot of stock options. Stock options ensure that management’s incentives are aligned with growth in at least the stock price (and most likely earnings growth too). You can motivate employees via communication, teamwork, culture building activities, and all that touchy-feely stuff. But at the end of the day, nothing motivates employees more at stocks options in growth companies. Employees have a huge motivation to work harder and help the company grow faster when they know that they will benefit financially from their efforts.

Thanks again, Troy for submitting this post! Here are a few recent articles Troy has written. 

Why a U.S. government shutdown won’t push the stock market down

Why “Sell in May and Go Away” works, and why we don’t use it

Readers, what do you think about Troy’s ideas for growth stocks?

If you invest in stocks, do you employ a similar strategy to Troy? If not, how does it differ?