DIY: Finding Great Growth Stocks
Screens for Selecting Stocks
A Strong Chinese Stock
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Sometimes you ask a simple question and you get an answer so complicated that you’re sorry you asked. That’s one of the discouraging truths about the universe.
Here’s the simple question: “How do I find great growth stocks?”
Since I work for a company that sells advice on stock investing, I have a couple of obvious suggestions, but I’ll keep them to myself, at least for a while.
The real question is, how can you, an individual investor, find leading growth stocks?
A few obvious choices probably don’t work.
For instance, you probably won’t find great growth stocks by scanning the lists of the day’s biggest gainers. All too often, the stocks making the biggest leaps during the day are low-priced issues that are rebounding after big losses. Plus, even if a stock trades at 10 or higher, a huge gain often signals a short-term climax in price action.
It’s also difficult to find stocks with big growth potential by watching the parade of pundits on financial TV shows. Most big fund managers use a valuation approach to stocks, so their recommendations focus on cheap stocks, rather than those with a chance of rapid price appreciation.
Financial blogs and the columnists on financial sites are fun and fascinating, but they’re too hit-or-miss to use as guidance in putting your hard-earned money to work.
No, the best way for the individual investor to find great growth stocks (short of using Cabot’s services) is to screen the market for growth characteristics.
The Wilshire 5000 Index was established in 1974 to track the value of every stock on the market that represents a firm headquartered in the United States and that trades on U.S. exchanges and has widely available pricing information. The market has grown since the Index was established, and now includes about 6,700 stocks.
So your job is to pick out 50 candidate stocks from among those 6,700 for further study and analysis.
What do you screen for?
Your most important screen is for price appreciation. You should set your screen to show you stocks that have risen 20% or more during the previous three months. This will eliminate stocks that are losing value, ones that are trading in a range and ones that are appreciating only gradually. (If you’re a little more technically minded, you can screen for stocks that have outperformed the S&P 500 over the same period.) Requiring that a stock has appreciated in price is an absolute must.
If you only have one screen, that’s the one you would use. The most bullish thing a stock can do is to go up in price. Price appreciation represents an improving opinion of the stock on the part of the investing community. And by keeping your time period at a month, you will exclude the one-day flash-in-the-pan stocks that rise and fall like mayflies.
If the markets are in generally good health, as they are now, you will need more screens to whittle down your list. I would suggest setting your screens to eliminate any stocks that trade under 10. Low priced stocks are just too volatile. I would also look for stocks that trade with adequate volume to ensure that you can buy and sell easily. Your liquidity screen should exclude stocks that trade fewer than 300,000 shares a day.
Once your list becomes manageable, you can begin to look for the fundamentals that support price appreciation. These supporting numbers include revenue and earnings growth (both quarterly and over the years), institutional sponsorship and after-tax profit margins.
Lastly, but very importantly, you will want to begin researching the business propositions of the companies you have selected. Are their products and services innovative, revolutionary and with potential appeal to a huge mass market? Are they the best in their industry? Is management seasoned, responsive and able to juggle the rise and fall of costs, demand, competition and expansion?
You need to consider everything before you put your money down. But the place to start is with price appreciation. The market is constantly processing all of the information I’ve talked about here, and the movement of a stock’s price is like a running tabulation of the results. Start with stocks that are going up and you won’t go far wrong.
[Editor’s Note: This method works. I know it works because that’s what I and the analysts of Cabot’s growth advisories—Cabot Market Letter, Cabot Top Ten Trader and Cabot China & Emerging Markets Report—actually do every day. We are constantly combing the markets to isolate the strongest stocks with the best growth credentials. And we start with price appreciation.
I will just point out that if you don’t have the time or the temperament to do the kind of screening I’ve described above, you can still have access to the results by subscribing to one of our growth advisories. For those who have a taste for life in the fast lane of the growth highway, I’d recommend Cabot China & Emerging Markets Report, the newsletter that I write. Chinese stocks are on a tear right now, and prospects are excellent.
To check out any of Cabot’s growth advisories (or our value, options, small-cap, income or multi-strategy advisories, for that matter), just click here.]
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My stock pick for today is a good representative of the current strength of Chinese stocks that trade on U.S. exchanges. The company is Perfect World (PWRD), an online game developer and operator that specializes in three-dimensional massively multiplayer online role playing games (MMORPGs). Perfect World’s big titles include Perfect World, Legend of Martial Arts, Perfect World II, Zhu Xian, Chi Bi, Pocketpet Journey West and Forsaken World. There are also casual games (like Hot Dance Party) and 3D and 2.5D games, but it’s the MMORPGs, based on the Angelica 3D game engine, that provide the lift.
So, following the screening rules I set up earlier, has PWRD increased in price over the past three months? The chart shows that PWRD closed on May 6 at 11.93. And it opened today at 21.94, which makes for an 83% price increase. Check.
Trading above 10? Check.
Adequate trading volume? Average daily trading volume for PWRD is 800,000 shares. Check.
Revenue and earnings growth? Well, Perfect World’s revenue was up 31% in 2011, but actually declined 7% in 2012. And both revenue and earnings were off slightly in the first quarter. (The company will announce Q2 results on August 19, after the market closes.) The after-tax profit margin was 23.6% in Q1.
Institutional sponsorship peaked back in 2009–2010, which is understandable, since the stock price dropped below 10 in 2011 and stayed there for all of 2012. Big investors are often reluctant to mess with stocks whose prices are in single digits.
PWRD sells at a reasonable P/E ratio of just 12, and the stock pays a respectable dividend with a forward annual yield of 1.9%.
So how about the story? Well, the online game business in China is certainly robust, and most Chinese portals offer some casual games and some combat games. Personally, I’m not qualified to judge the quality of Perfect World’s games, how frequently they’re updated and how often new titles are introduced.
Many of those questions will likely get at least partially answered in the upcoming Q2 earnings release on August 9. A dedicated growth investor will make it a point to listen to the conference call after the release to hear how management talks about the company’s performance, its plans and its projections for future revenue, earnings and new games.
I don’t have Perfect World in the portfolio of Cabot China & Emerging Markets Report right now. It certainly qualifies on the basis of price appreciation, but I’m waiting to see how the earnings report goes. I think my initial price screen has given me (and you) a very interesting stock to follow. Let’s see how it does.
Sincerely,
Paul Goodwin
Editor of Cabot China & Emerging Markets Report
and Cabot Wealth Advisory
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