Remember Research in Motion (now Blackberry Limited – BBRY)? What about Krispy Kreme Doughnuts? How about Crocs (CROX)? Or maybe even Webvan, the online grocery delivery company that went bankrupt during the bursting of the dot-com bubble? These are all examples of once heralded growth companies that lost their mojo along their growth expansion ways.

Not every stock can grow to the $80+ billion market cap stratosphere like Apple Inc. (AAPL), Starbucks Corp. (SBUX), and Wal-Mart Stores (WMT), so finding companies with the right mixture of growth characteristics can be challenging. Objective stock market observers can disagree on the ingredients of a successful growth stock recipe, but generally speaking, the real explosive appreciation in stock prices come from those companies that can compound earnings growth over longer periods of time.

But how can one discover the Holy Grail of compounding earnings? At Sidoxia Capital Management, there are a handful of key factors we look for in successful growth companies. In the hyper-competitive global marketplace, these are crucial questions we want adequately answered before we invest our clients’ money:

  • Does the company sell a product or service that cuts costs?
  • Does the company offer a product or service with unique entertainment value?
  • Does the company offer a superior product or service compared to its competitors?

Even if a target investment can affirmatively answer two or three of these questions, often the most important question is the following:

  • Does the company have a sustainable competitive advantage in providing a product or service?

If the company does not have some type of durable competitive advantage, then some other company can just copy the product or service, and sell it at a lower price. This sadly leads to margin and P/E (Price-Earnings) multiple compression – both negative outcomes.

The aforementioned factors are not the end-all, be-all for successful growth stocks, but rather the minimum price of admission. Even if the previous criteria boxes are sufficiently checked off, the company being researched must still be fairly or attractively priced. For example, it doesn’t take a genius to figure out Apple is a successful company with unique advantages. More specifically, the company has $240 billion in cash, $50 billion in profits, and $215 billion in revenue. The real question becomes, is the stock fairly or attractively priced?

Although Apple appears attractively valued at current prices, in many other instances that is not the case. Often, great companies have been discovered by a large swath of investors, and therefore trade at significant premiums, which increases the risk profile or reduces the upside potential of the investment.

Sucking the Last Puff

If a company’s product or service isn’t superior, cut costs, or entertain at a reasonable/attractive valuation, then investing is like taking the last puff or drag out of a cigarette butt. Some value investors are good at this craft, but often these managers get caught into so-called “value traps” – ask Bill Ackman about Valeant Pharmaceuticals (VRX). Many value investors thought they found a bargain when they bought Valeant shares after it fell -80% in price. The stock subsequently has fallen another -50%…ouch!.

It’s worth noting that growth can come from many different areas. Even mature industries can produce periods of cyclical growth, however identifying cyclical winners is challenging. The art for the investment manager is determining whether growth in a target investment is sustainable. In many instances, companies temporarily benefit from a rising tide that lifts all boats, before the tide goes out and sinks fundamentals down to lower levels.

Growth investing can be a dangerous hobby for short-term traders because the price volatility stemming from ever-changing earnings growth expectations creates excessive trading, taxes, and transaction costs. However, for long-term investors, the great growth manager, T. Rowe Price, summed it up best here:

“The growth stock theory of investing requires patience, but is less stressful than trading, generally has less risk, and reduces brokerage commissions and income taxes.”

 

Growth investing is both a science and an art, but does not require a degree in rocket science. If you can focus on the important growth criteria, and combine it with a long-term disciplined valuation process, you will be well on your way to discovering the growth stock Holy Grail.