SIVY ON STOCKS from money.com
October 11, 2000

Seven questions to ask before buying a growth stock

Look for long-distance runners not sprinters -- these questions can help
determine if you're buying growth that can be sustained.

By Michael Sivy

In theory, no company should be able to show earnings increases that are
way above average for very long. Whenever a market offers opportunities
that can lead to rapid growth, those high profits attract more and more
competitors. As these firms try to undercut each other, profit margins --
and growth rates -- deteriorate.

Nonetheless, companies from Cisco to Pfizer to Wal-Mart manage to remain
stars for years. They can do this in one of two ways -- either by
maintaining a leading position in a fast-growing industry or by gaining
market share and operating more efficiently in an average industry. In
either case, the companies need some sort of competitive advantage --
proprietary technology, patents or even just a management system that's
hard to duplicate.

Since growing companies go after the most profitable markets first and
eventually face tough competition, even the most dynamic businesses slow
down sooner or later. So here are seven questions to help determine if a
stock still has plenty of growth ahead of it.

DOES THE COMPANY HAVE A UNIQUE PRODUCT OR SERVICE?
Growth companies have to earn above-average profits. To do that for any
length of time, a company must offer an innovative product or service that
isn't readily available elsewhere. For example, The Gap's stock soared in
the late 1990s, but began slipping in 1999 because there were no barriers
to prevent other companies from successfully copying the retailer's casual
apparel style.

DOES THE FIRM HAVE RECURRING REVENUES?
Truly sustainable earnings growth comes from steadily rising revenues, not
from cost cutting, financial restructuring or lower taxes. The best kind of
revenues are recurring. Microsoft, for instance, has long been able to sell
revised versions of its operating system every few years.

IS THE COMPANY EARLY IN ITS GROWTH CURVE?
Since nearly all growth stocks eventually plateau, make sure you're getting
in early. Be careful if everyone is familiar with the company, knows about
its success and assumes it will grow forever. Dell attracted an almost
fanatical following of investors who believed that the company's
direct-selling strategy would enable it to keep grabbing market share from
competitors. But market share can't be increased indefinitely, and
eventually Dell's sales growth disappointed.

IS THE COMPANY AT THE FOREFRONT OF ITS INDUSTRY?
Even when an industry is booming, there's no guarantee that all companies
in it will continue to prosper. Take IBM, which for decades led many major
technological advances and was the must-own tech stock. But by the
mid-1980s, the company fell behind in cutting-edge technology. IBM relied
far too heavily on old-line mainframe computers and failed to adapt
successfully to the PC era -- and its stock began a decade-long slide.

IS THE RETURN ON EQUITY HIGHER THAN 15%?
Some companies show high earnings growth only because they borrow to
finance expansion. But eventually, they can't afford to borrow any more.
Sustainable growth is best funded with the earnings that a company retains
after it pays dividends. Those retained earnings are added to shareholders'
equity -- and it's the profits earned on such additional equity that
provide most of a company's long-term earnings growth. These potential
profits can be gauged with a measure know as return on equity, or ROE. As a
rule, a company needs an ROE above 15% to sustain a growth rate above 12%.

IS THE COMPANY'S DEBT LOW--OR AT LEAST STABLE?
The best growth companies have little or no debt. Those with debt less than
20% of long-term capital (equity plus long-term debt) shouldn't have any
trouble financing their growth.

DO YOU BELIEVE THE SHARE PRICE CAN DOUBLE IN FIVE YEARS?
A stock that meets all these tests should be able to double in price over
five years. Stocks with earnings growth of 15% or more can reach that
target if their P/Es stay constant and earnings come through as expected.
Stocks with slower growth, will need some increase in their P/Es, while
stocks with much faster growth can afford to have their P/Es erode a bit.
Whichever type of stock you favor, make sure that the growth and P/E
numbers you're counting on aren't wildly out of line, based on the
company's industry and its own history.