The following is a contribution from Troy at The Financial Economist. If you’re interested in contributing to Frugal Rules, please consult our guidelines and contact us.
Are you new to investing? If so, then the first thing that you probably heard was “invest in a stock that’s of value.” That’s a pretty ambiguous phrase, and is pretty useless, just like the phrase “buy low sell high” (come on guys, any third grader knows that you need to buy low sell high). That ain’t the secret to investing. The “secret” is the how part.
Now there are two kinds of stocks worth buying – the first being an undervalued stock, and the second being a stock with impressive growth potential. In this post, I’m going to focus on growth stocks, although I will explain why I’m not going to focus on undervalued stocks.
Below Book Value
Undervalued stocks were how Warren Buffett first started out back in the 1950s. In his words, these were “disgusting cigarette butts that were worth one last free puff.” In other words, undervalued stocks are stocks so cheap that their asset value is even greater than their market capitalization. This can mean that, sometimes, a company’s valuation on the stock exchange is LESS than the amount of cash it has in the bank! Thus, when an investor puts his money into an undervalued stock, he is immediately experiencing more bang for his buck.
The reason why I’m not really going to focus on undervalued stocks is because these days, they’re so rare and hard to come by. Back in Buffett’s day, they were more common (thanks to the Great Depression that kept investor sentiment in check in the 1940s and 1950s). But today, it’s almost impossible to find severely undervalued stocks UNLESS the entire stock market just experienced a major bear market (as we did in 2009). In bull markets like the one we’re experiencing right now, it’s almost impossible to find undervalued stocks.
But, there are always growth stocks out there, waiting for savvy investors to pick them up.
Growth stocks are stocks that may not be cheap right now but have a lot of growth potential (meaning that the company has a lot of potential to increase its revenues and profits). Thus, although you’re not making money almost instantly like when you buy undervalued stocks, in the long run growth stocks far outpace the returns of undervalued stocks because there’s compounded growth. Here are some factors that come into play when valuing growth stocks.
For growth stocks, how strong the management team is becomes a critical factor regarding the company’s future. A weak management team that’s un-innovative and slow can spell disaster for a company. A company can have the brightest staff, but like any poorly led organization, a company with poor management cannot be a successful growth company that you should invest in. Growth stocks need good management teams that will continue to grow the company in the right direction.
So what defines management strength?
- The leader at the helm must be strong, firm, and open to new ideas. Contrary to popular opinion, the CEO DOESN’T need to be a genius. Some of the best leaders in corporate history weren’t the Einsteins of the world but were great at spotting talent and putting employees in the right positions.
- Teamwork. The management team needs to all be on the same page. This doesn’t mean that there shouldn’t be disagreements – in fact, constant back and forth debate between management is a sign of the health of the company. Only through rigorous debate and analysis can a company make the right decisions that put it on the fastlane to growth. But, when a decision is made, everyone needs to get behind that decision and support it. That’s teamwork.
- As a general rule of thumb, companies with too many layers of management aren’t growth companies. As companies mature over time, layer after layer of stifling management is piling on, thereby further suppressing growth “hormones” (if that’s what you want to call it).
How good are the company’s products? Is the company a leader in its industry? Are it’s products highly innovative, or does it have to constantly play catch up to competitors? Growth stocks are companies whose products are the industry standard and highly desired by consumers, not some laggard who picks up the crumbs (in terms of sales).
Products are the lifeline to profits and revenues, which are the lifeline to corporate health. Strong product lines, especially INNOVATIVE product lines, equate into high potential growth in the company’s sales (and therefore stock price).
Now this is the big one that many growth investors fail to recognize. The industry that the company is in plays a HUGE factor (potentially one of the biggest).
Is the company’s industry a growth industry, or is it a matured, “traditional economy” industry? As the saying goes “all boats rise with the rising tide.” If the “tide” ( or industry) isn’t rising, it’s very difficult for an individual company to become a growth stock. An example of this would be the retail industry. With so many established market players out there, it is extremely difficult for an upstart to grow like crazy and challenge the Establishment (Wal-Mart, Target, etc). But if the entire industry is growing (expanding market pie), then a company can easily grow along with it (as was in the case with the computer industry in the 1980s).
Another question you have to consider is “is this industry becoming obsolete, or is it on the forefront of cutting edge technology?” A sinking tide sinks all ships, meaning that for industries that are dying out, don’t expect to find any growth stocks there. For examples, industries like rail-roads fall into this category – as railroad traffic sinks across the board, companies are fighting just to stay alive, much less grow.
Editor’s note: Thanks to Troy for sharing his insight with us today. As an investor I am commonly looking at many, if not all, of these areas as a part of my due diligence related to stock research.
Photo courtesy of: 401(k)2013