How to Compose a Growth Portfolio 

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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 dividend yields.

Growth Rates
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.

Table 13-4
Growth Stock Portfolio Based on Growth in Excess of 30 Percent

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 growers.

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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