How to Compose a Growth Portfolio
Growth investors look for companies with above-average growth
rates. These can be companies with consistently high sales growth.
Growth investors are willing to pay high multiples of earnings for
companies with high growth rates, which explains why growth
stocks generally have high P/E multiples. Stocks such as Google
and Starbucks trade at P/E ratios of greater than 40, and these
multiples might expand as these companies grow at their expected
growth rates. Should growth stocks not be able to sustain their
high growth rates, their stock prices are severely punished. This
occurred when Cisco Systems could not sustain its growth rate of
35 to 50 percent in 2000; its stock price declined from the mid-$50s
to the midteens.
Growth stocks had an incredibly good run of consistent earnings
growth in the slow-growth economic environment in the
United States during the period 1995 to April 1999. This was in part
due to low inflation and declining interest rates. The P/E ratios of
the large-cap growth stocks were expanding to historically high
levels, suggesting a definition of growth stocks: companies with
higher-than-average growth in sales and earnings with high P/E
ratios and high price-to-book ratios. The high P/E ratios mean that
investors are willing to pay a high premium to buy these stocks.
However, if there are disappointments in the sales and/or earnings
growth, these stocks get severely punished and therefore are considered
to be more risky, with a greater potential for losses.
Investors have lower expectations for value stocks. Consequently,
any sales or earnings disappointments will cause smaller losses.
Generally, growth companies reinvest their earnings to fund more
growth rather than paying them out in dividends. If growth
companies do pay dividends, they are relatively small with low
There is no precise definition of the exact growth rate that distinguishes
a growth stock from a value stock. Investors can choose
any growth rate to determine their universe of growth stocks and
then extrapolate their growth rates into the future.
There are a number of measures of growth. Investors can focus
on revenue growth, earnings-per-share growth, return-on-equity
growth, or cash-flow-per-share growth from year to year.
Selecting a Growth Portfolio
The first step is to determine your criteria for selecting growth
stocks from a stock screen. Table 13–4 shows stocks selected using
revenue growth rates of greater than 50 percent for the past five
years and earnings-per-share growth rates in excess of 30 percent
for the past three years. This is not a recommendation to buy these
particular stocks because information, financial conditions, and
circumstances change over time.
Reasons for Selecting These Stocks
The growth stocks selected for Table 13–4 had relatively low P/E
ratios for companies with high sales and earnings growth rates.
Another strategy for selecting growth stocks might be to pick
industry leaders such as Cisco Systems (telecom equipment),
Google (Internet search), Best Buy (retail), Amgen (biotechnology),
and Apple Computer (iPod) even though their P/E ratios are
higher than the stocks selected in Table 13–4. Cisco Systems does
not make the list because its growth declined after the Internet bubble,
when communications equipment orders dried up. However,
Cisco Systems has recovered in 2006 and managed to grow its sales
and earnings for the year. Generally, the leading stocks in their
respective industries have sustainable sales and earnings growth.
Growth Stock Portfolio Based on Growth in Excess of 30 Percent
A growth investor needs some justification to purchase high P/E
ratio stocks, and that justification is growth rates. Generally,
investors look for growth stocks with P/E ratios that are less than
their growth rates. The time to buy growth stocks is when they have
underperformed value stocks, such as in 2006, and they are trading
at reasonable P/E ratios. This strategy is known as growth at a reasonable
price (GARP). The question to answer with growth stocks is,
“How much should I pay for the company’s earnings?” If the company
appears to be able to maintain or increase its growth rate into
the future, then paying a higher multiple of earnings might be
justified. Google, Inc., is such an example. Google is trading at a
lofty P/E multiple, and as long as Google can grow its earnings at
the same or greater growth rate, the stock price will continue to rise.
However, any disappointments in sales or earnings growth will
punish the stock price severely.
A good starting point to select growth stocks for a portfolio is
to look at the fastest-growing sectors of the economy. At the time of
this writing, biotechnology and technology sectors were the fastest
When growth stocks are trading at rich valuations, investors need to
look at the returns to justify the lofty prices. For example, Starbucks,
a growth company, was punished when it announced quarterly
earnings that were shy of analysts’ expectations. However, Starbucks
announced that it was going to increase its growth through the opening
of more stores around the world. Look for companies that have
or will post superior earnings returns into the future rather than
those with half the picture, namely, tremendous sales growth but flat
or decreasing returns.
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