How to Find Growth Stocks: 7 Signs to Watch For
Dear Rich Lifer,
Buy low, sell high.
That’s every investor’s dream, right?
But reasonably priced stocks that still offer high growth potential are hard to come by.
A lot of investors buy value stocks and expect ten times returns. But if you want above average gains, most value stocks won’t cut it.
What companies offer the best returns? And what indicators should you be looking at?
Today we break down seven signs of high-potential growth stocks, including how to find them, key indicators, and some examples of high growth stocks on the market today.
If you’re investing for growth and looking for the next triple-bagger, here’s what you need to know.
Growth Stocks vs. Value Stocks
As the name suggests, growth stocks are stocks that increase their revenue and earnings at a faster rate than the average business in their industry or the market as a whole.
Growth stocks are attractive to many investors because Wall Street often values a company based on a multiple of its earnings (its profits), which may be diminished if the company is reinvesting most of its leftover cash in further expansion.
Growth-focused companies are typically at the forefront of macro trends like the rise of e-commerce and advances in financial technology.
Amazon, for example, was a pioneer in the e-commerce space when it started selling books online in 1995. Alphabet (Google) built the most user-friendly search engine and innovative online advertising platform the world has ever seen.
Other sectors that tend to breed growth stocks are in biotechnology and pharmaceuticals. This is typically where you’ll find companies innovating and revolutionizing a market landscape.
Value stocks on the other hand are stocks with prices that appear lower relative to their overall financial performance, as measured by fundamentals like revenue, dividends, yield, earnings and profit margins.
While growth stocks can be undervalued too, the main difference is value stocks are not necessarily on an upward trajectory like growth stocks. Investors seeking out value stocks are placing a bet that the current stock price does not reflect the company’s true intrinsic value but that someday it will.
If you’re looking to buy value stocks, you really need to do your due diligence to figure out which stocks are worth your time since it’ll likely be a while before you see a return.
Why Buy High-Growth Stocks?
There are several reasons why an investor might choose to add growth stocks to their portfolio, but the main reasons are typically:
- For higher returns
- To outpace inflation
- For swing trading (less stressful than day trading)
By now you’re probably wondering how you find the best growth stocks? To make your search easy, we’ve outlined these seven signs of high potential growth stocks…
- Small- or Mid-Cap Stocks
Unlike large-cap stocks which are great for dividends, smaller companies that are still expanding typically have higher growth potential.
Small- and mid-cap stocks also fly under the radar with many fund managers because of their size and low liquidity. Because of that, retail investors have the opportunity to own these smaller companies early until they grow large enough for the fund managers to start paying attention.
- Less than 50% Dividend Payout Ratio
A company in an early stage of growth should be retaining most of its profits for business expansion. That’s why we prefer a growth company to have a dividend payout ratio of 50% or less.
Companies with high dividend payout ratios are usually large and mature companies like Coca-Cola where growth has slowed down and most of the profits are returned to shareholders in dividends.
- 3-5 Years of Growth
Success leaves clues and a growth company should have a track record of tangible growth over the last 3-5 years. We look for consistent rising revenues, profits and cash flow to ensure we don’t get caught up with companies that only sell dreams to wide-eyed investors.
Some CEOs and companies are masterful when it comes to painting a nice growth picture for investors, like how they’re entering new markets, expanding production capacity and growing customer demand.
Meanwhile the numbers tell a different story. It’s best to wait for hard evidence of stable and sustainable growth before investing.
- Strong Growth Drivers
Having a past track record of growth is one indicator but it doesn’t guarantee a company’s future growth potential. Some companies might grow quickly over the first few years then stagnate thereafter.
This is why you must study the company’s industry, business model and management team very carefully. Read all their annual reports, attend the AGMs and ask the hard questions. The more informed you become, the clearer it will be whether or not this company is poised for the moon or destined to flatline.
This can take a bit more time but your time invested will be worth it if you are able to choose a real growth stock.
- Strong Balance Sheet
A company must have a strong balance sheet — a good cash position and low, manageable debt levels. There’s nothing worse than investing in a company that’s growing but quickly finds itself in financial trouble a year or two later because of high levels of debt.
If the company can’t manage its debt, they have to slow or stop expansion to focus on paying down their loans. In the worst-case scenarios, a company goes bankrupt if it can’t repay its debt obligations. So always make sure the growth stock you invest in is not overleveraged.
- High Return on Equity
Warren Buffet lists return on equity (ROE) as one the of the most important criteria for evaluating companies in his annual letters. ROE measures how much profit is generated with the money shareholders have invested in a company.
A high ROE means management is able to allocate capital efficiently to generate returns for shareholders. If you’re investing in a company retaining most of its profits for growth, it should be able to show it can use its equity to generate high returns for shareholders.
If not and ROE is low, the company might be better off paying out the majority of their earnings in a dividend to shareholders. Look for low-debt companies that generate an ROE of 15% or higher over the past 3-5 years.
- Strong Cash Flow
For dividend stocks, income investors generally look for stable free cash flow because they want a company to pay out the free cash flow as dividends. For growth stocks, free cash flow is usually low or negative because growth companies reinvest much of their cash into capital expenditure (capex) to grow their business.
So instead of free cash flow, a better way to measure growth companies is by looking at operating cash flow. Look for consistently rising operating cash flow. Declining operating cash flow means a company is not generating enough new cash flow from its capex.
The idea of investing in a company that’s on an upward trajectory is appealing to many investors.
But cutting through the noise can prove challenging. Pay close attention to these seven signs when researching your next growth stock and you’ll come out ahead.
To a Richer Life,
The Rich Life Roadmap Team