A 4-Step Guide to Growth Investing

Try this social experiment with some of your friends or colleagues who regularly air their views about the stock market. Ask them why they invest in the stock market.

Chances are, they will look at you as if you are an alien from another planet. Most will answer: To make money, of course!

Then you point out that money can be made by selling shoes through the Internet, or by smuggling gold, or by becoming a movie star, or a doctor or a lawyer. Why from the stock market?

You may get the odd well thought out response to that last question; others will hem and haw, and then blurt out the truth: To make some quick money.

That is precisely the wrong reason to enter the stock market. Stocks provide inflation-beating returns over the long-term. For that to happen, stocks need to be picked carefully, and then held for the long-term.

There are two schools of thought about stock investing - value investing and growth investing. Those interested in value investing can go through the 7-Step Guide.

Those interested in finding the 'next Infosys' or the 'next L&T' may like to follow the 4-Step Guide to evaluate growth stocks:-

1. Revenue Growth - ideally the average revenue growth of a company over the past 5 years

2. Profitability - during the initial years of a company's existence, growth may require in-flow of cash through debt or additional equity. Thereafter, it will be operating and net profit margins that will determine growth

3. Efficient use of Capital - two indicators of capital efficiency are Return on Assets (ROA) and Return on Equity (ROE) ratios

4. Industry Position/Competitive Advantage - qualitative assessments about whether a company can continue to grow and outperform.

Read more from this investopedia.com article.

Related Post

What is the Return on Assets (ROA) ratio?

4 Ways to Identify a Risky Stock

You are a small investor reasonably active in the market. Using cricketing metaphors, you have 'hit a few sixes' with your selected stocks. You have also 'got out for a duck' a few times.

Your portfolio is full of mid-cap and small-cap growth stocks - in the hope that some of them will turn into multibaggers. But you are not sure which ones are too risky and should be sold.

Ask yourself some of these questions:

1) A stock you bought rose 10% quickly, but has since slipped down 20% on some adverse news. What will you do?
2) A stock falls 10% just after you buy it, but you keep holding it to get back your 'buy price'. It falls another 5%. Will you hold on, or buy more, or sell?
3) A stock takes off like a rocket as soon as you buy it, rising 60% in 3 months. Do you take part profit, or sell off, or buy more at the next dip?
4) A stock gives you 150% returns in 1 year, and then corrects 30%. Will you book profit, or buy more?

These are common questions faced by many small investors. How you answer these questions - not to me, but to yourself - will determine how successful you can be as an investor.

In other words, you should have a strategy on how you will deal with risky stocks in different market situations. 

Your strategy should be clearly written down in a notebook or diary with bullet points, and referred to on a regular basis. Otherwise, you will be prone to repeat the same mistakes over and over again.

Need help in figuring out risky stocks that should be avoided? You don't need to go far. Here is a link to an article from investopedia.com that will guide you:
4 Things That Make a Stock a Risky Bet

Dow Jones (DJIA) index chart pattern - Nov 27, '09

The Dow Jones (DJIA) made another attempt to climb away from the important 10360 level, mentioned last week as the barrier to cross for the bull rally to sustain. In a holiday-shortened week, the Dow twice moved above the 10500 level, but Friday's profit booking brought the index down below the 10360 level. It finally closed marginally lower for the week.
The 6 months bar chart pattern of the Dow Jones (DJIA) index isn't looking that different from a week back:-

The bull rally on lower volumes continues as the bulls have managed to brush aside all efforts by the bears to bring the index down. All three EMAs are still moving up and the index is above them.

The technical indicators are looking slightly weaker. The slow stochastic is in the overbought zone, where the %K has moved slightly below the %D. The RSI moved down after touching the overbought zone. The MFI is above the 50% level but moving down. The MACD has moved down a bit and is touching the signal line.

So is it time for the bears to throw in the towel? As per this article, market sentiments are turning overly bullish, which could provide just the contrarian opportunity that the bears could try and exploit. Fundamentals are yet to catch up with a market that has been driven upwards by a flood of liquidity and dollar carry-trade.

Bottomline? The Dow Jones (DJIA) index chart pattern is maintaining the bullish sequence of higher tops and bottoms. Ride the rally, but keep booking partial profits.

(Note: At the time of writing this post, the Dow is marginally up but still below the 10360 level.)

Does the Price of a Stock reflect its Value?

"Price is what you pay. Value is what you get." - Warren Buffett

Many small investors face a problem with stocks that have a 'high price'. They don't want to buy them, because they feel they can't afford them. They prefer to buy stocks that have a 'low price', because they appear more affordable and capable of giving high returns.

Last weekend, I was discussing the state of the markets with a friend and inevitably the discussion veered towards what stocks are worth buying now. I suggested that he look at a medical devices stock trading at 200 or a hospitality stock trading at 80.

His response was typical. He wanted to buy the 'cheaper' stock. I pointed out that the cheaper stock was actually more expensive on several counts - it had a Re 1 face value (vs. Rs 10 for the other), its net profit margin was less than half, and its Return on Equity (RoE) was just about a fifth.

What he said next left me speechless: 'When I can buy 1250 shares with Rs 1 Lakh, why should I buy only 500?' 

Such an approach to investments is illogical. This fixation on price and affordability is one of the prime reasons why small investors do not become successful investors. It is like saying: 'I can't afford the price of gold, so I'll buy some brass instead.'

The 'Efficient Market' theory was postulated by French mathematician Louis Bachelier in 1900 and developed further by Eugene Fama in his PhD thesis at the University of Chicago in the 1960s. It states that stock prices reflect all available information and adjusts to any new information as and when it becomes known.

It is very unlikely that an individual investor can consistently outperform the market indices because the financial news and information he uses for his stock selections is already available to every one else. Any future information will only be available on a random basis, and will affect stock prices randomly. Therefore, investors will be better off investing their money in a good index fund.

The Efficient Market theory anticipates rational behaviour from investors. But by nature, human beings tend to be irrational. And nowhere more so than in the stock market. Otherwise, why would they enter when the market has already gone up, and refrain from buying at the depths of a bear market?

Experienced investors learn to pick up value-stocks that may appear expensive but are cheap on a valuation basis - at or near market bottoms. Inexperienced investors chase after cheaper growth-stocks that are actually more expensive value-wise.

To answer the question: a stock's price tends to reflect its underlying value in the longer term. In the shorter-term, price and value mismatches do happen, that allow smart investors to build wealth.

About Growth Stocks and Value Stocks

Should the title of this post be changed to Growth stocks vs. Value stocks? So many dichotomies have become part of our everyday lives - like Good vs. Evil, Black vs. White, East vs. West, Fundamental analysis vs. Technical analysis - that we have come to believe them as truths.

The reality is different. By creating compartments and divisions through our imagination or dogma, we get into behavioural patterns that are detrimental to our emotional and financial well-being. Once we decide to cut the Gordian knot of needless differences, life and investments become so much simpler.

Enough philosophy for a short week of trading. Let us get down to the nitty-gritty.

What is a Growth stock?

These are stocks belonging to companies that have shown a consistent above-average growth in sales or earnings in the past, and are expected to maintain the rate of growth in future. One measure of growth is RoE (Return on Equity) above 15%.

To fuel such growth, cash is a major requirement. So companies often forego dividend payments to plow the earnings back into the business. When the earnings are inadequate to fund the growth, companies resort to share issues and debt.

Typically, these are high P/E stocks with volatile price movements that make them risky to own. Investors expect to make large capital gains and often get trapped by the 'greater fool theory'.

What is a Value stock?

These are stocks belonging to companies that are considered to be trading at a level lower than their intrinsic values, as determined by fundamental analysis of sales, earnings, dividend payments.

These stocks have low P/E or P/BV ratios and high dividend yields. Hence they have lower risk and a bigger 'Margin of Safety'. Value stocks tend to out-perform growth stocks during bear markets and under-perform in the later stages of bull markets.

Like in life, which has more shades of gray than black or white, there is no distinct dividing line between a Growth stock and a Value stock.

No company can have a high growth rate forever. Sooner or later, as its size increases, growth rate will begin to slow down. If it survives, it will become a stalwart and pay regular dividends and grow steadily.

The key phrase is: 'if it survives'. Taking on too much debt, or issuing too many shares in the singular pursuit of growth can weaken the balance sheet so badly that the company can collapse under the weight of its interest payments. Stocks from the retail and realty sectors come to mind.

Should investors choose Growth stocks or Value Stocks for their portfolios? It need not be an either/or situation. Why not choose Growth stocks and Value stocks?

How about using the 80-20 rule? Keep 80% of your portfolio in Value stocks, and 20% in Growth stocks. Remember that the best time to look for Value stocks is when the stock market is down, not when it is up 70% from its recent low. That doesn't mean that Value stocks are not available in bull markets. They are just very difficult to find.

(Do you have an opinion about any good growth or value stocks in the current market? Please share it here for the benefit of other readers.)