Former Cabot CEO Timothy Lutts always attributes his interest in growth investing to his father, Cabot Founder Carlton Lutts. So, naturally, he took the time to review the best-performing growth stocks Cabot had identified over a 10-year period with a focus on finding fundamental characteristics of great growth stocks.
He identified six.
These aren’t just any six characteristics. These are the six fundamental characteristics that correlated most highly with profits in a 10-year study of stocks bought for the Model Portfolio of the Cabot Growth Investor.
In other words, after 10 years of investing, these are the factors that were best at bringing us profits. Might another 10 years bring a different result? We’ll let you know in 10 years. Until then, however, we feel pretty good about these six characteristics of great growth stocks.
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So here they are, in Tim’s words.
The Six Most Important Characteristics of Great Growth Stocks
#1: Invest in Mass Markets
This one is well-known to many investors. The more potential customers there are for a product or service, the greater the possibility that the business will be a success and the greater the possibility the investment will be a success. But how big is a mass market? Sometimes it’s hard to know where to draw the line; there is no right answer. Choosing between a manufacturer of curling equipment (that sport where they slide the rock down the ice) and a manufacturer of shoes, I’d go with the shoe manufacturer. Its mass market was just one reason we once added Crocs (CROX), the maker of “funny-looking plastic shoes,” to Cabot Growth Investor’s Model Portfolio and grabbed a 307% gain in it.
#2: Market Dominance/Barriers to Entry
Patents often provide a great barrier to entry. And if there’s no one else providing competition, you can be sure those patents are strong. Intuitive Surgical (ISRG) was the classic example of that, as its one-of-a-kind surgical robotic systems were untouched by competitors due to the firm’s great patent protection. As for market dominance, this can be harder to measure, but you know it when you see it. When Alphabet (GOOG) first came public, there were many competitors (Yahoo, Ask Jeeves, Excite), but Google was the clear leader, and advertisers stampeded to the company’s door so as to be exposed to the largest number of users.
#3: Accelerating Earnings Growth
There’s no ambiguity here. If a company’s earnings growth rate (measured by comparing the earnings of one quarter to the earnings of the same quarter in the prior year) increases for two quarters in a row, growth is accelerating. In general, faster growth is better growth, and a company whose earnings growth rate is accelerating (whether it’s due to increased revenues or more efficient operations) is becoming an increasingly attractive investment. My perception is that acceleration tends to be underappreciated by investors (some just don’t see it), so buying when you first recognize it usually works out very well.
#4: Triple-Digit Revenue Growth
In our experience, companies growing revenues at triple-digit rates (100% or better) tend to be small and less well-known; thus they’re ripe for buying by institutions as they grow. Many of the market’s biggest winners had triple-digit revenue growth early in their runs—when Google came public it was growing at a rate of 125%, Baidu (BIDU) at 150%, Crocs (CROX) saw quarterly growth of 162% and even Wynn Resorts (WYNN) saw revenues leap north of 100% when it first opened its doors.
#5: High Profit Margins
Software companies tend to have very high margins because they deal in code that costs nothing to ship or store, while iron ore companies (for instance) tend to have very low margins. All things equal, you want companies with huge margins, which shows not only that their product or service is in huge demand, but that the business model is highly efficient and is spinning off a ton of cash. That said, if you dive into a lower-margin business, that can work, but it’s usually best to find the firm that has the largest profit margins within that industry—it all comes down to finding the best company in the group.
#6: Excellent, Innovative Management
Henry Ford, Thomas Watson, Ray Kroc, Jack Welch, Walt Disney, Akio Morita, Sam Walton, Bill Gates, Larry Ellison, Steve Jobs, Meg Whitman, Jeff Bezos, Craig Venter, and Dennis Kozlowski (for a while) were (and are) all great managers who led their companies to success by thinking differently. Admittedly, there is no hard and fast measurement of management talent, but because this is the most important characteristic of all—and I think it always will be—it’s worth thinking about very hard. Most managers are nowhere near as good as those legends. But when you find a top manager—especially one with a record of prior successes—you should give him or her a little extra leeway. Top managers have a way of overcoming obstacles through a combination of vision, enthusiasm, and leadership
Interestingly, several criteria that had been favorites of ours before this 10-year study proved to have a far poorer record of finding winners, so we weigh them much more lightly now.
We used to think low debt was good; turns out it didn’t matter much.
We used to think high recurring income (think razor blades for Gillette or film for Kodak) was a good thing. Well, it may be so for conservative companies later in their growth cycles, but it didn’t improve our success rate.
In sum, our advice to investors working to grow their wealth by investing in growth stocks is to weigh those six criteria above heavily. If you keep them in mind as you go about evaluating companies, you’ll be able to identify great growth companies more easily, and you’ll be able to dismiss lower-potential companies faster, too.
But there’s one more important characteristic we look for in a growth stock, and that’s momentum. Momentum (technically, the degree to which a stock is outperforming the market) provides confirmation that other investors are excited about a company’s future, too. It’s such an important factor that we have an entire advisory, Cabot Top Ten Trader, that uses momentum as its primary screening factor. There’s nothing like investing in hot stocks to get your blood boiling.
To learn more about Cabot Top Ten Trader, click here.
What do you look for in great growth stocks?
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*This article is periodically updated to reflect market conditions.
