Nine Characteristics of Great Growth Stocks

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How to Find Great Growth Stocks

We spend a lot of time giving you stock recommendations—because that’s the #1 thing you want from us.

But today, I’m going to step back from the individual stock level, and shed some light on the decisions that go into choosing these stocks. We do love that you trust us to find great growth stocks, but you’ll be a better investor if you can evaluate companies on your own as well, because the fact is, great growth stocks can be found anywhere, if you keep your eyes open.

So here, in no particular order, are nine characteristics that can help you find great growth stocks.

1. Profitability

All things being equal, companies that have positive earnings, and are growing those earnings, are far more likely to bring you investment profits than those that are unable to make a profit. If a company isn’t making money now, there’s no guarantee that it will ever make money. And if it doesn’t make money, its stock won’t get very far.

Yes, there are exceptions; Amazon.com (AMZN) and Tesla Motors (TSLA) were big winners for us before they made any money. But in general, your odds will be better is you invest in companies that have already proven that they have a successful business model, like Netflix (NFLX) and Alphabet (GOOGL) and then climb on board while they work to grow that business.

2. Low (or No) Debt and Strong Balance Sheet

A strong balance sheet gives a company power and flexibility. With plenty of cash on hand, the company doesn’t always need to be asking bankers or shareholders for permission to expand. Plus, when times get tough—and they do in every industry—a strong balance sheet provides a cushion, exactly when those bankers (and shareholders) are most reluctant to provide more capital.

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Apple (AAPL) is famous for having a strong balance sheet today; it had more than $200 billion on hand in the latest quarter. Microsoft (MSFT) is also flush, with more than $100 billion in cash.

Of course, those companies are huge, so growth potential is somewhat limited. But Adobe Systems (ADBE), the king of publishing software—and growing profits nicely since it began migrating to the “Creative Cloud”—has a strong balance sheet and much greater growth potential.

3. Large Target Market

Would you rather sell a drug that treats a rare disease that afflicts a few thousand people, or a drug that treats a condition that afflicts millions, like diabetes or high blood pressure? While the first might allow for higher prices, the latter provides much more opportunity for growth. Given the choice, we like to opt for mass markets.

Many of the market’s biggest winners historically —Nike (NKE), Home Depot (HD), McDonald’s (MCD), Expedia (EXPE)—have targeted mass markets, and I have no doubt that many more will appear in the years ahead.

4. Strong Business Model

For decades, business school students have been taught about Gillette’s business model, where the company basically gave away the razor so consumers would continue buy razor blades. More recently, we saw Keurig Green Mountain post great growth numbers (thanks to recurring sales of its coffee pods) before it was taken private earlier this year.

Now, with the internet a major factor in many businesses, subscription fees are an increasingly common way for companies to get recurring income. America Online was a pioneer at this (remember how hard it was to get the service stopped?), and today Adobe (ADBE) and Netflix (NFLX) are thriving with similar business models.

Starbucks (SBUX) did not require its customers to purchase repeatedly, but the habit developed regardless, and that led to great growth and profitability.

Pricing power can also be a key factor. Companies in commodity businesses, most famously oil companies, are at the mercy of the commodity’s price. Contrarily, companies that can set their own prices—often raising them repeatedly like Mylan Labs (MYL) did recently—can rack up great profits.

5. Sustainable Key Drivers of the Company’s Success

Just because a company is successful today doesn’t mean it will remain successful. Ideally, you need some indication the company’s growth will continue, due to either powerful outside forces or innovative management.

TAL Education (XRS) is a Chinese private schooling company that’s been enjoying great growth as more and more Chinese citizens can afford its offerings. Properly managed, such growth should continue for years.

Salesforce (CRM), on the other hand, enjoys no demographic forces that ensure continued growth, but the company’s enormous installed base ensures a high degree of recurring revenue as corporate users upgrade their systems and Salesforce further penetrates every global business market.

Facebook (FB), similarly, has achieved remarkable growth by offering new ways for people to stay in touch. But there are no barriers to entry in the field, so competitors are a never-ending concern.

And Twitter (TWTR) might be one of these! Already the company has revolutionized the world of communications (in 140 characters or less) and if it is properly managed (it hasn’t been so far), Twitter may also enjoy great financial success and expand its offerings.

6. A Large “Moat” or “Key Advantage” Innovation Edge

The ability to keep competitors at bay with either patents or trade secrets—like the formula for Coca-Cola—can be invaluable to a company’s long-term success.

Microsoft (MSFT) had a lock on the operating software for the early decades of the personal computer market thanks to its contract with International Business Machines (IBM), which made the PCs.

Match.com (MTC) has tremendous intellectual property, which it guards zealously.

And Taser (TASR) has such effective patent protection that its brand name is on the way to becoming a generic term for electroshock defense systems.

7. Significant Ownership of Stock by Key Executives

A high level of ownership by top executives ensures that the interests of shareholders are aligned with the interests of management. The ideal amount of insider ownership might be between 5% and 40%. If it’s more than 50%, the principals(s) might reward themselves with lucrative compensation packages rather than serving the interests of shareholders. And if it’s less than 5%, there might not be enough alignment with shareholders.

At Amazon (AMZN), founder Jeff Bezos owns 17% owns the company, which is still a great growth stock.

At Oracle (ORCL), founder Larry Ellison owns 27% of the company.

And at Campbell Soup (CPB), which is no longer a growth company but is a great source of dividends, insiders (descendants of founder John Dorrance), own 37% of the shares.

8. Low Recurring Capital Investment

Some industries, like automobile manufacturing and homebuilding, are very material-intensive, which occasionally can be very costly. Others, like licensing, require very little capital investment and thus can expand more easily.

Nvidia (NVDA), which designs a wide variety of video chips, but doesn’t manufacture anything, is a notable winner in this regard.

And Zillow (Z), even though it is on the periphery of the homebuilding industry, can grow with minimal capital investment because its inventory is all digital.

9. Management Skill and Talent

When all is said and done, perhaps the most important factor of all is the one conveyed by management, both the CEO and the managers under him. I’ve already mentioned Jeff Bezos of Amazon, and there’s no question that Steve Jobs was the stemwinder of Apple in its glory days.

But the managers under the top man also matter, so it’s worth noting that a company’s reputation also matters. In the technology field today, for example, where competition for workers is strong, companies like Alphabet (GOOG) Boeing (BA), Disney (DIS) and Apple (APPL) have an advantage in that they are very attractive places to work and thus can land the top engineers.

In the end, there’s no magic formula to unearthing great growth stocks; everything matters to some extent. But the more you are able to think about these important factors, the more you will increase your ability to identify—and stick with—the leading growth stocks of the future.

The Great Game of Business

The above nine points about identifying great growth stocks were all taken from the book, The Great Game of Business: Investing to Win, written by my brother, Robert T. Lutts.

The Great Game of Business

Rob is the founder and CEO of Cabot Wealth Management, and he wrote this book to give his clients and other investors some insights into the firm’s decision-making process, particularly when it comes to identifying great growth stocks.

My brother’s company and mine are legally separate, but share common roots in that we both learned the basics of growth investing from our father, Carlton Lutts, who was passionate about it. In fact, in the book you’ll find a lot of the ideas that originated with our father.

The book is an easy read, organized into bite-sized chapters. These include:

Company Life Cycle vs. Investment Cycle

Small is Better … But Avoid Penny Stocks

The Trend is Your Friend

Debt is a Four-Letter Word

The Cheapest CEO in America

Do They Have a Porsche in the Parking Lot?

How High is “High” and How Low is “Low”

When Do You Sell a Stock?

And many more.

The Great Game of Business: Investing to Win is available on Amazon.

Timothy Lutts

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