How to discover growth stocks

Growth stock hunters believe that there are no excess returns to be gained from investing in the tried and true 'blue chip' stocks representative of a mainstream stock index such as the Dow Jones Industrial Average and the S & P 500. The big profits in the stock market rest in ferreting out the next growth stocks, the next Cisco.

For example, Cisco Systems, Inc., now the leading supplier of high-performance internetworking products for linking computer system networks, traded at $4-1/2 per share shortly after going public in 1990 (adjusted for 2-for-1 stock splits in both 1991 and 1992. At the time, Cisco Systems generated less than $30 million in annual revenues. In 1992, the innovative company looks to reach $325 million in revenues and earn around $1.25 per share.

Alert emerging growth investors who discovered Cisco Systems in its formative years and had the conviction to see its tremendous prospects, despite huge competitors such as IBM and NEC Corpora­tion, earned substantially higher returns than the market averages. From a low of $4-1/2 per share in 1990, the market price of Cisco Systems stock had already soared to $52 per share in 1992.

Growth stocks and their subset, emerging growth stocks, are well-managed companies operating in industries where earnings and dividends are expected to grow faster than inflation and the overall economy. They are expected to maintain their exceptional growth momentum through economic retractions as well as during economic prosperity.

Typically, growth stocks are not located in the traditional well-known sectors but in new and upcoming fields, such as computers, telecommunications, health care, and biotechnology.

Major characteristics of growth stocks include:

• Higher price/earnings ratios than the market average,
• Substantial potential for above-average, long-term price appreciation,
• Price volatility, and
• Conservation of capital to fuel growth, therefore little or no dividend payouts in the early years.

For the smaller, emerging growth stocks, price volatility can be even more pronounced due to small capitalization, which makes their shares less liquid; there may be a shortage of available financial and operational information by which to properly judge the company's merits or prospects; investor sentiment swings for large versus small company investments can cause the market price of emerging growth stocks to drop substantially despite rising revenues and earnings and the typical pattern of earnings gains interruptions due to high research and development and expansion expenses can cause investors to flee the stock.

James W. Broadfoot III in his book, Investing in Emerging Growth Stocks: Making Money With Tomorrow's Blue Chips spelt out how to understand emerging growth stock investing and learn how to pick the right emerging growth stocks for above average returns.

Obviously, the higher returns associated with emerging growth investments also carry with them a higher degree of risk. That's why Broadfoot stressed that investors planning to enter this brand of in­vesting must have a stomach for risk, financial staying power since emerging growth stocks go through cycles of poor performance, and the ability to make a sufficient commitment of time and effort.

Emerging growth stock, screening standards set forth by Broadfoot include the following:

• Avoid companies with two down earning years in the past five
• Choose companies with a minimum average 20 per cent revenue and earnings growth
• Avoid any firm with return on average equity below 13 per cent
• Avoid firms with debt in excess of 30 percent of total capital.

If the firm passes the above tests, consider the growth prospects of the industry (including the degree of industry fragmentation), the level of competition, and the quality of management.

Broadfoot warned about stumbling blocks to the company's success and higher stock prices. A lack of visibility, lengthening sales cycles, and new product dependence can each work to short-circuit the company's potential. In addition, too rapid a growth can wreak havoc with financial and operational controls, causing the company to stumble.

As a warning, Broadfoot said that when emerging growth companies run into trouble, such as a significant earnings shortfall, sell as fast as possible and ask questions later.

Finally, be patient. Emerging growth investing profits don't occur overnight. When you do hit upon a winner, ride it for all its worth; you need the exceptional gains from your growth stock winners to make up for the mistakes that come with the emerging growth investing territory.