Investing for Growth

SIVY ON STOCKS from money.com
October 9, 2000

Investing for growth

Every portfolio needs a healthy dose of growth. Finding it is easy --
here's how to not overpay for it.

By Michael Sivy

Stock prices follow earnings. In fact, over a long stretch of time, rising
corporate profits are the only force that can keep share prices moving
higher. Investors may pay up for the earnings of a popular company, which
boosts the price/earnings ratio. But while rising P/Es can lift stocks for
a few years, there's a limit to how high they can go.

As a result, growth investing, or seeking out companies with above-average
earnings growth, should be a key part of your strategy. It's also the
simplest approach to the stock market.

Historically, the S&P 500 has returned around 12% a year. So if you can
find a company with earnings growing faster than that, the stock will
eventually outpace the market -- provided its earnings come through as
expected and that the stock was fairly priced to begin with.

What's a fair price? P/E ratios and price/cash-flow ratios are the most
common measures of how expensive a stock is. A lot of factors influence
P/Es, including interest rates, the company's track record and the industry
it's in. But one reliable tool is to compare a company's P/E to its
projected earnings growth. Ideally, you don't want to buy at a P/E much
more than the growth rate, and in a normal stock market, there are plenty
of such bargains. But over the past five years, they have become harder and
harder to find.

Today most high-quality companies with double-digit earnings growth have
P/Es that are at least 1.5 times their growth rate. For example, shares of
a company with 14% earnings growth would trade at a P/E of 21 or higher. If
you're interested in the most popular growth stocks, you may have to grit
your teeth and pay even more -- P/Es that are double the growth rates, for
instance. But you have to draw the line somewhere. Hold off on buying
stocks that are trading at P/Es more than 2.5 times their growth rates, no
matter how good the companies are. When a stock with a P/E that high
stumbles, its shares drop like a rock.

Some of your best bargains will be found at the opposite end of the
spectrum, with companies that have earnings growth around 12%. With those
stocks you may want to add in the dividend yield to get a total return
estimate. For instance, a stock with 11% growth and a 3% yield might really
be able to return a total of 14%. Getting a stock like that for a P/E below
20 could be a great deal.

For some stocks -- particularly industrial companies -- cash flow provides
another reliable benchmark for value. You can find the amount of cash a
company generates each year listed in brokerage reports or other standard
research sources, such as the Value Line Investment Survey (some firms also
report EBITDA, a similar measure). When a stock is selling at less than 10
times cash flow per share, it may well be a compelling value.

Whichever spot on the growth spectrum you favor, remember that the key to
long-term profits is consistency. Companies with above-average growth that
you can buy and hold indefinitely are the most valuable additions to your
portfolio. Since commissions and other fees are a significant drag on
returns for individual investors, the less often you buy and sell, the less
you have to think about expenses. In addition, if you don't trade much, you
won't have to worry about mistakes in your timing.