Six Characteristics of Great Growth Stocks

I’m a growth stock investor at heart, in part because my father was a growth stock investor at heart, so today I’m going to focus on six fundamental characteristics of great growth stocks.

These aren’t just any six characteristics. These are the six fundamental characteristics that correlated most highly with profits in a ten-year study of stocks bought for the Model Portfolio of the Cabot Growth Investor.

In other words, after ten years of investing these are the factors that were best at bringing us profits. Might another ten years bring a different result? I’ll let you know in ten years. Until then, however, I feel pretty good about these.

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So here they are, with the very best criteria – in the time-honored tradition of lists – coming last.

#6 Huge 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 307% gain in it.

#5 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 and remains the classic example of that, as its one-of-a-kind surgical robotic systems remain 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 Google (GOOGL) 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.

#4 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.

#3 Triple-digit revenue growth – In my 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. Almost all solar power companies were enjoying triple-digit revenue growth (100% of better) earlier this year when their stocks were hot … and most still are. Many of the market’s biggest winners had triple-digit revenue growth early in its run–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.

#2 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 they’re 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.

#1 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.

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Interestingly, several criteria that had been favorites of ours before this ten-year study proved to have a far poorer record of finding winners, so we weight 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.

And finally, we used to favor small companies over large ones, simply because small companies can grow faster. But among the stocks we bought, we had more success with large ones! The reason: the volatility inherent in smaller stocks knocked us out more frequently.

In sum, my 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 – perhaps write them on your arm the same way my 15-year-old son writes his homework assignments – I guarantee that 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 a whole newsletter, 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; with the rig.

To learn more about Cabot Top Ten Trader, click here.

Timothy Lutts

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