How a Growth Investor Thinks about Valuation

P/E as a Predictor of Stock Success

Cause and Effect

This Potential Leader Looks Ready to Move

I’m a growth stock guy, always have been, always will be. Growth is the perspective I used for the very first stock I bought (Gillette, back when it was growing at 20%-plus rates) and has been for the hundreds of trades ever since.

That means that, when I first examine a company, the first questions that cross my mind are: What is the firm’s sales and earnings growth, both past and future? Does the firm have a new and revolutionary product or service? Generally speaking, does the company look to have a multi-year runway of growth ahead? And, of course, is the stock itself acting well, informing me that institutional investors are enamored of the firm’s prospects?

To many investors, there is one glaring item missing from this list—the stock’s valuation! Whether it’s traditional P/E ratios or something more exotic, nearly every investor puts a stock through a rough valuation test, or at the very least, looks up the valuation and compares it to some benchmark. While these investors aren’t necessarily value-oriented, they still believe in getting a good deal.

But I don’t! And because of that, I inevitably get emails from subscribers asking “Are you sure about XYZ stock? The stock is up nicely during the past year and it trades at 75 times earnings!”

You see, most investors, even if they’re not strict Ben Graham adherents, believe that a lower valuation leads to good results … Or that a sky-high valuation leads to poor results. And that thinking makes perfect sense in the real world—what you pay for a house, for instance, is usually the most important factor in whether it proves to be a good investment.

But the stock market is a contrary creature; when dealing with growth stocks, you generally get what you pay for. If valuation was the key to finding the next big winner, you can be sure I’d constantly be running screens on value measures.

Yet it turns out that things like P/E ratios are not great predictors of future growth stock performance. In fact, the vital truth is that many investors are confusing the cart with the horse: Valuation is often the RESULT of great performance, not the CAUSE of it.

And the reason for that is supply and demand—in any market cycle there are only so many true, institutional leading stocks. I am not talking about decent growth names that run for a few months and then peter out. I’m talking about the best of the best, the ones that have genuinely revolutionary products that change the way we work and live, or have some sort of new concept that’s taking huge market share (or is possibly starting a brand new industry). Examples since 2009 include Apple, Netflix, Lululemon, Baidu and Chipotle Mexican Grill.

When you’re in a bull market, the thousands of mutual, hedge and pension funds have to own stocks. And you can bet your backside that they’re going to build positions in the real leaders that have the best products, the fastest sales and earnings growth and the surest prospects to continue growing rapidly for many years.

Of course, all bull markets end, and when they do, many of these true leaders top permanently (example: Cisco in 2000), which is why market timing is so important. But while the bull market lasts, the simple fact is that these and other leaders are under big demand from big investors.

Thus, it’s buying demand that creates the great performance, which in turn causes the valuation to baloon. And what causes the buying demand in the first place is the growth, the unique products and the enticing prospects for the future. It’s worth remembering as you hunt for new buys.

Switching over to the current environment, I like what I see. The market actually bottomed back in early June, but anyone who tried buying strength for the six or seven weeks following that low was burned. In my mind, what really transpired was a prolonged bottoming process, where the indexes chopped around (there were an incredible nine swings, both up and down, of at least 4% in the Nasdaq from that June low until the end of July!!) as money very slowly rotated from defensive stocks (tobacco, big telecom) into more traditional growth areas (chips, networking, software, retail, etc.).

That said, I am not super-bullish right now; while enough leadership has emerged to carry the market higher, I wouldn’t say the advance is overly broad. And there still hasn’t been the type of power in the market that commonly characterizes strong advances. Sure, some of that is likely due to the calendar (I’m pretty sure most big investors will be on the beach this week), but it would warm my heart to see some huge-volume advances.

Even so, I am not souring on the market—if anything, the advance has picked up a little steam as the sellers have run out of ammunition. So now the job is to identify the stocks with the best upside potential. One name that I’m still intrigued by is LinkedIn (LNKD), a stock that hasn’t yet joined the ranks of leadership, yet has all the makings of a big winner.

The company is one of the few out there today that is revolutionizing an entire industry (recruiting and hiring); this isn’t some mild improvement over but a totally different way for companies to find the talent they need. LinkedIn has quickly grown into a good-sized firm ($724 million of annual revenue during the past four quarters) thanks to quarter after quarter of 80%-plus revenue growth.

Plus, it’s not just the recruiting business that’s booming for the company—LinkedIn also makes good money in premium subscriptions and advertising, as it aims to make its website a professional portal of sorts. The number of unique visitors grew to 106 million in the second quarter, up from 103 million the prior quarter and 82 million the year before. It’s a similar story with total page views, which numbered 9.3 billion in the second quarter, up from 7.1 billion a year ago. All of that traffic is attracting advertisers, who wish to sell to a very defined, targeted audience.

All together, analysts see earnings totaling 63 cents per share this year (up 80%) and $1.31 in 2013 (up 108%) and, if you want to look very far into the future, $2.15 in 2014.

Yet the stock hasn’t gotten going yet! Why? I think a lot of it has to do with the horrid performance of Facebook’s stock, which has been cut in half since its first day of trading. A lot of investors imagine a link between Facebook and LinkedIn, seeing both as poster children for the recent wave of Internet IPOs.  (It isn’t helping that smaller IPOs like Zynga and Groupon are also heading south.)

But, logically, there’s no real link between Facebook and LinkedIn; one is social media, while the other is revolutionizing a humongous industry. And, of course, one is growing rapidly and exceeding analyst estimates every quarter, while the other has slowing growth and its future strategy (especially with mobile advertising) is being questioned!

Technically, LNKD has been basing since early May, but what I really like is how the stock has finally, after a lot of wide-and-loose action, tightened up—shares have pulled back calmly since gapping higher on earnings in early August, have found some support around 100 and have begun to perk up. If you don’t own any, I think you could nibble here and look to add shares on a powerful push above 115.

Oh, and one more thing—don’t worry about the stock’s huge valuation (215 times current earnings!).  Yes, it’s expensive, but it’s clear the company isn’t trying to maximize its bottom line right now; instead, it’s focusing on expanding services and digging a deeper moat to keep out any potential competition. Long-term profit margins, which currently are in the high single digits, could easily double, and revenues are growing like mad. As I wrote above, I think institutional investors will be willing to pay up for a piece of a truly unique company like LinkedIn.

All the best, 

Michael Cintolo
Editor of Cabot Market Letter 

Michael Cintolo

Your Guide to Winning Growth Stocks

Michael Cintolo is a growth stock and market timing expert. His Cabot Growth Investor, with its legendary Model Portfolio, is recommended for all investors seeking to grow their wealth.

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