Stock Investing For Dummies, 5th Edition - Paul Mladjenovic (2016)
Part II. Before You Start Buying
Chapter 8. Investing for Long-Term Growth
IN THIS CHAPTER
Balancing growth and value
Using strategies to select good growth stocks
What’s the number-one reason people invest in stocks? To grow their wealth (also referred to as capital appreciation). Yes, some people invest for income (in the form of dividends), but that’s a different matter (I discuss investing for income in Chapter 9). Investors seeking growth would rather see the money that could have been distributed as dividends be reinvested in the company so that (hopefully) a greater gain is achieved when the stock’s price rises or appreciates. People interested in growing their wealth see stocks as one of the convenient ways to do it. Growth stocks tend to be riskier than other categories of stocks, but they offer excellent long-term prospects for making the big bucks. If you don’t believe me, just ask Warren Buffett, Peter Lynch, and other successful, long-term investors.
Although someone like Buffett is not considered a growth investor, his long-term, value-oriented approach has been a successful growth strategy. If you’re the type of investor who has enough time to let somewhat risky stocks trend upward or who has enough money so that a loss won’t devastate you financially, then growth stocks are definitely for you. As they say, no guts, no glory. The challenge is to figure out which stocks make you richer quicker; I give you tips on how to do so in this chapter.
Short of starting your own business, stock investing is the best way to profit from a business venture. I want to emphasize that to make money in stocks consistently over the long haul, you must remember that you’re investing in a company; buying the stock is just a means for you to participate in the company’s success (or failure). Why does it matter that you think of stock investing as buying a company versus buying a stock? Invest in a stock only if you’re just as excited about it as you would be if you were the CEO in charge of running the company. If you’re the sole owner of the company, do you act differently than one of a legion of obscure stockholders? Of course you do. As the firm’s owner, you have a greater interest in the company. You have a strong desire to know how the enterprise is doing. As you invest in stocks, make believe that you’re the owner, and take an active interest in the company’s products, services, sales, earnings, and so on. This attitude and discipline can enhance your goals as a stock investor. This approach is especially important if your investment goal is growth.
Becoming a Value-Oriented Growth Investor
A stock is considered a growth stock when it’s growing faster and higher than the overall stock market. Basically, a growth stock performs better than its peers in categories such as sales and earnings. Value stocks are stocks that are priced lower than the value of the company and its assets — you can identify a value stock by analyzing the company’s fundamentals and looking at key financial ratios, such as the price-to-earnings (P/E) ratio. (I cover company finances in Chapter 11 and ratios in Chapter 11 and Appendix B.) Growth stocks tend to have better prospects for growth in the immediate future (from one to four years), but value stocks tend to have less risk and steadier growth over a longer term.
Over the years, a debate has quietly raged in the financial community about growth versus value investing. Some people believe that growth and value are mutually exclusive. They maintain that large numbers of people buying stock with growth as the expectation tend to drive up the stock price relative to the company’s current value. Growth investors, for example, aren’t put off by P/E ratios of 30, 40, or higher. Value investors, meanwhile, are too nervous to buy stocks at those P/E ratio levels.
However, you can have both. A value-oriented approach to growth investing serves you best. Long-term growth stock investors spend time analyzing the company’s fundamentals to make sure that the company’s growth prospects lie on a solid foundation. But what if you have to choose between a growth stock and a value stock? Which do you choose? Seek value when you’re buying the stock and analyze the company’s prospects for growth. Growth includes but is not limited to the health and growth of the company’s specific industry, the economy at large, and the general political climate (see Chapters 13 and 15).
The bottom line is that growth is much easier to achieve when you seek solid, value-oriented companies in growing industries. (To better understand industries and sectors and how they affect stock value, see Chapter 13.) It’s also worth emphasizing that time, patience, and discipline are key factors in your success — especially in the tumultuous and uncertain stock investing environment of the current time (2015–2016).
Value-oriented growth investing probably has the longest history of success compared to most stock-investing philosophies. The track record for those people who use value-oriented growth investing is enviable. Warren Buffett, Benjamin Graham, John Templeton, and Peter Lynch are a few of the more well-known practitioners. Each may have his own spin on the concepts, but all have successfully applied the basic principles of value-oriented growth investing over many years.
Choosing Growth Stocks with a Few Handy Tips
Although the information in the previous section can help you shrink your stock choices from thousands of stocks to maybe a few dozen or a few hundred (depending on how well the general stock market is doing), the purpose of this section is to help you cull the so-so growth stocks to unearth the go-go ones. It’s time to dig deeper for the biggest potential winners. Keep in mind that you probably won’t find a stock to satisfy all the criteria presented here. Just make sure that your selection meets as many criteria as realistically possible. But hey, if you do find a stock that meets all the criteria cited, buy as much as you can!
For the record, my approach to choosing a winning growth stock is probably almost the reverse method of … uh … that screaming money guy on TV (I won’t mention his name!). People watch his show for “tips” on “hot stocks.” The frenetic host seems to do a rapid-fire treatment of stocks in general. You get the impression that he looks over thousands of stocks and says, “I like this one” and “I don’t like that one.” The viewer has to decide. Sheesh.
Verifiably, 80 to 90 percent of my stock picks are profitable. People ask me how I pick a winning stock. I tell them that I don’t just pick a stock and hope that it does well. In fact, my personal stock-picking research doesn’t even begin with stocks; I first look at the investing environment (politics, economics, demographics, and so on) and choose which industry will benefit. After I know which industry will prosper accordingly, then I start to analyze and choose my stock(s).
After I choose a stock, I wait. Patience is more than just a virtue; patience is to investing what time is to a seed that’s planted in fertile soil. The legendary Jesse Livermore said that he didn’t make his stock market fortunes by trading stocks; his fortunes were made “in the waiting.” Why?
When I tell you to have patience and a long-term perspective, it isn’t because I want you to wait years or decades for your stock portfolio to bear fruit. It’s because you’re waiting for a specific condition to occur: for the market to discover what you have! When you have a good stock in a good industry, it takes time for the market to discover it. When a stock has more buyers than sellers, it rises — it’s as simple as that. As time passes, more buyers find your stock. As the stock rises, it attracts more attention and therefore more buyers. The more time that passes, the better your stock looks to the investing public.
When you’re choosing growth stocks, you should consider investing in a company only if it makes a profit and if you understand how it makes that profit and from where it generates sales. Part of your research means looking at the industry and sector (see Chapter 13) and economic trends in general (which I cover in Chapter 15).
Looking for leaders in megatrends
A strong company in a growing industry is a common recipe for success. If you look at the history of stock investing, this point comes up constantly. Investors need to be on the alert for megatrends because they help ensure success.
A megatrend is a major development that has huge implications for much (if not all) of society for a long time to come. Good examples are the advent of the Internet and the aging of America. Both of these trends offer significant challenges and opportunities for the economy. Take the Internet, for example. Its potential for economic application is still being developed. Millions are flocking to it for many reasons. And census data tells us that senior citizens (over 65) will be the fastest-growing segment of the U.S. population during the next 20 years. How does the stock investor take advantage of a megatrend? Find out more in Chapter 13.
Because small companies can be the ones poised for the most potential growth, check out Chapter 14 to get in early on some hot stocks.
Comparing a company’s growth to an industry’s growth
You have to measure the growth of a company against something to figure out whether its stock is a growth stock. Usually, you compare the growth of a company with growth from other companies in the same industry or with the stock market in general. In practical terms, when you measure the growth of a stock against the stock market, you’re actually comparing it against a generally accepted benchmark, such as the Dow Jones Industrial Average (DJIA) or the Standard & Poor’s 500 (S&P 500). For more on stock indexes, see Chapter 5.
If a company’s earnings grow 15 percent per year over three years or more and the industry’s average growth rate over the same time frame is 10 percent, then the stock qualifies as a growth stock. You can easily calculate the earnings growth rate by comparing a company’s earnings in the current year to the preceding year and computing the difference as a percentage. For example, if a company’s earnings (on a per-share basis) were $1 last year and $1.10 this year, then earnings grew by 10 percent. Many analysts also look at a current quarter and compare the earnings to the same quarter from the preceding year to see whether earnings are growing.
A growth stock is called that not only because the company is growing but also because the company is performing well with some consistency. Having a single year where your earnings do well versus the S&P 500’s average doesn’t cut it. Growth must be consistently accomplished.
Considering a company with a strong niche
Companies that have established a strong niche are consistently profitable. Look for a company with one or more of the following characteristics:
· A strong brand: Companies such as Coca-Cola and Microsoft come to mind. Yes, other companies out there can make soda or software, but a business needs a lot more than a similar product to topple companies that have established an almost irrevocable identity with the public.
· High barriers to entry: United Parcel Service and Federal Express have set up tremendous distribution and delivery networks that competitors can’t easily duplicate. High barriers to entry offer an important edge to companies that are already established. Examples of high barriers include high capital requirements (needing lots of cash to start) or special technology that’s not easily produced or acquired.
· Research and development (R&D): Companies such as Pfizer and Merck spend a lot of money researching and developing new pharmaceutical products. This investment becomes a new product with millions of consumers who become loyal purchasers, so the company’s going to grow. You can find out what companies spend on R&D by checking their financial statements and their annual reports (more on this in Chapters 11 and 12).
Checking out a company’s fundamentals
When you hear the word fundamentals in the world of stock investing, it refers to the company’s financial condition and related data. When investors (especially value investors) do fundamental analysis, they look at the company’s fundamentals — its balance sheet, income statement, cash flow, and other operational data, along with external factors such as the company’s market position, industry, and economic prospects. Essentially, the fundamentals indicate the company’s financial condition. Chapter 11 goes into greater detail about analyzing a company’s financial condition. However, the main numbers you want to look at include the following:
· Sales: Are the company’s sales this year surpassing last year’s? As a decent benchmark, you want to see sales at least 10 percent higher than last year. Although it may differ depending on the industry, 10 percent is a reasonable, general yardstick.
· Earnings: Are earnings at least 10 percent higher than last year? Earnings should grow at the same rate as sales (or, hopefully, better).
· Debt: Is the company’s total debt equal to or lower than the prior year? The death knell of many a company has been excessive debt.
A company’s financial condition has more factors than I mention here, but these numbers are the most important. I also realize that using the 10-percent figure may seem like an oversimplification, but you don’t need to complicate matters unnecessarily. I know someone’s computerized financial model may come out to 9.675 percent or maybe 11.07 percent, but keep it simple for now.
Evaluating a company’s management
The management of a company is crucial to its success. Before you buy stock in a company, you want to know that the company’s management is doing a great job. But how do you do that? If you call up a company and ask, it may not even return your phone call. How do you know whether management is running the company properly? The best way is to check the numbers. The following sections tell you the numbers you need to check. If the company’s management is running the business well, the ultimate result is a rising stock price.
Return on equity
Although you can measure how well management is doing in several ways, you can take a quick snapshot of a management team’s competence by checking the company’s return on equity (ROE). You calculate the ROE simply by dividing earnings by equity. The resulting percentage gives you a good idea whether the company is using its equity (or net assets) efficiently and profitably. Basically, the higher the percentage, the better, but you can consider the ROE solid if the percentage is 10 percent or higher. Keep in mind that not all industries have identical ROEs.
To find out a company’s earnings, check out the company’s income statement. The income statement is a simple financial statement that expresses this equation: sales (or revenue) minus expenses equals net earnings (or net income or net profit). You can see an example of an income statement in Table 8-1. (I give more details on income statements in Chapter 11.)
Table 8-1 Grobaby, Inc., Income Statement
2015 Income Statement
2016 Income Statement
To find out a company’s equity, check out that company’s balance sheet. (See Chapter 11 for more details on balance sheets.) The balance sheet is actually a simple financial statement that illustrates this equation: total assets minus total liabilities equals net equity. For public stock companies, the net assets are called shareholders’ equity or simply equity. Table 8-2 shows a balance sheet for Grobaby, Inc.
Table 8-2 Grobaby, Inc., Balance Sheet
Balance Sheet for December 31, 2015
Balance Sheet for December 31, 2016
Total assets (TA)
Total liabilities (TL)
Equity (TA minus TL)
Table 8-1 shows that Grobaby’s earnings went from $7,000 to $12,000. In Table 8-2, you can see that Grobaby increased the equity from $35,000 to $40,000 in one year. The ROE for the year 2015 is 20 percent ($7,000 in earnings divided by $35,000 in equity), which is a solid number. The following year, the ROE is 30 percent ($12,000 in earnings divided by $40,000 in equity), another solid number. A good minimum ROE is 10 percent, but 15 percent or more is preferred.
Equity and earnings growth
Two additional barometers of success are a company’s growth in earnings and growth of equity.
· Look at the growth in earnings in Table 8-1. The earnings grew from $7,000 (in 2015) to $12,000 (in 2016), a percentage increase of 71 percent ($12,000 minus $7,000 equals $5,000, and $5,000 divided by $7,000 is 71 percent), which is excellent. At a minimum, earnings growth should be equal to or better than the rate of inflation, but because that’s not always a reliable number, I like at least 10 percent.
· In Table 8-2, Grobaby’s equity grew by $5,000 (from $35,000 to $40,000), or 14.3 percent ($5,000 divided by $35,000), which is very good — management is doing good things here. I like to see equity increasing by 10 percent or more.
Watching management as it manages the business is important, but another indicator of how well the company is doing is to see whether management is buying stock in the company as well. If a company is poised for growth, who knows better than management? And if management is buying up the company’s stock en masse, that’s a great indicator of the stock’s potential. See Chapter 20 for more details on insider buying.
Noticing who’s buying and/or recommending a company’s stock
You can invest in a great company and still see its stock go nowhere. Why? Because what makes the stock go up is demand — having more buyers than sellers of the stock. If you pick a stock for all the right reasons and the market notices the stock as well, that attention causes the stock price to climb. The things to watch for include the following:
· Institutional buying: Are mutual funds and pension plans buying up the stock you’re looking at? If so, this type of buying power can exert tremendous upward pressure on the stock’s price. Some resources and publications track institutional buying and how that affects any particular stock. (You can find these resources in Appendix A.) Frequently, when a mutual fund buys a stock, others soon follow. In spite of all the talk about independent research, a herd mentality still exists.
· Analysts’ attention: Are analysts talking about the stock on the financial shows? As much as you should be skeptical about an analyst’s recommendation (given the stock market debacle of 2000–2002 and the market problems in 2008), it offers some positive reinforcement for your stock. Don’t ever buy a stock solely on the basis of an analyst’s recommendation. Just know that if you buy a stock based on your own research, and analysts subsequently rave about it, your stock price is likely to go up. A single recommendation by an influential analyst can be enough to send a stock skyward.
· Newsletter recommendations: Independent researchers usually publish newsletters. If influential newsletters are touting your choice, that praise is also good for your stock. Although some great newsletters are out there (find them in Appendix A) and they offer information that’s as good as or better than that of some brokerage firms’ research departments, don’t base your investment decision on a single tip. However, seeing newsletters tout a stock that you’ve already chosen should make you feel good.
· Consumer publications: No, you won’t find investment advice here. This one seems to come out of left field, but it’s a source that you should notice. Publications such as Consumer Reports regularly look at products and services and rate them for consumer satisfaction. If a company’s offerings are well received by consumers, that’s a strong positive for the company. This kind of attention ultimately has a positive effect on that company’s stock.
Making sure a company continues to do well
A company’s financial situation does change, and you, as a diligent investor, need to continue to look at the numbers for as long as the stock is in your portfolio. You may have chosen a great stock from a great company with great numbers in 2014, but chances are pretty good that the numbers have changed since then.
Great stocks don’t always stay that way. A great selection that you’re drawn to today may become tomorrow’s pariah. Information, both good and bad, moves like lightning. Keep an eye on your stock company’s numbers! To help minimize the downside risk, see the nearby sidebar “Protecting your downside” for an example. For more information on a company’s financial data, check out Chapter 11.
PROTECTING YOUR DOWNSIDE
I become a Johnny-one-note on one topic: trailing stops. (See Chapter 17 for a full explanation of trailing stops.) Trailing stops are stop losses that you regularly manage with the stock you invest in. I usually advocate using them, especially if you’re new to the game of buying growth stocks. Trailing stops can help you, no matter how good or bad the economy is (or how good or bad the stock you’re investing in is).
Suppose that you had invested in Enron, a classic example of a phenomenal growth stock that went bad. In 1999 and 2000, when its stock soared, investors were as happy as chocoholics at Hershey. Along with many investors who forgot that sound investing takes discipline and research, Enron investors thought, “Downside risk? What downside risk?”
Here’s an example of how a stop-loss order would have worked if you had invested in Enron. Suppose that you had bought Enron in 2000 at $50 per share and put in a stop-loss order with your broker at $45. (Remember to make it a good-till-canceled, or GTC, order. If you do, the stop-loss order stays on indefinitely.) As a general rule, I like to place the stop-loss order at 10 percent below the market value. As the stock went up, you’d have kept the stop loss trailing upward like a tail. (Now you know why it’s called a “trailing” stop; it trails the stock’s price.) When Enron hit $70, your stop loss would have changed to, say, $63, and so on. At $84, your new stop loss would have been at $76. Then what?
When Enron started its perilous descent, you’d have gotten out at $76. The new price of $76 would have triggered the stop loss, and the stock would have been automatically sold — you’d have stopped the loss! Actually, in this case, you could call it a “stop and cash in the gain” order. Because you’d have bought the stock at $50 and sold at $76, you’d have pocketed a nice capital gain of $26 (52 percent appreciation — a-do-en-ron, a-do-en-ron!). Then you would have safely stepped aside and watched the stock continue its plunge.
But what if the market is doing well? Are trailing stops a good idea? Because these stops are placed below the stock price, you’re not stopping the stock from rising upward indefinitely. All you’re doing is protecting your investment from loss. That’s discipline! The stock market of 2004–2008 was fairly good to stock investors as the bear market that started in 2000 took a break. If a bear market continues, trailing stop strategies will again become very useful because a potential decline in the stock price will become a greater risk.
Heeding investing lessons from history
A growth stock isn’t a creature like the Loch Ness monster — always talked about but rarely seen. Growth stocks have been part of the financial scene for nearly a century. Examples abound that offer rich information that you can apply to today’s stock market environment. Look at past market winners, especially those during the bull market of the late 1990s and the bearish markets of 2000–2010, and ask yourself, “What made them profitable stocks?” I mention these two time frames because they offer a stark contrast to each other. The 1990s were booming times for stocks, whereas more recent years were very tough and bearish.
Being aware and acting logically are as vital to successful stock investing as they are to any other pursuit. Over and over again, history gives you the formula for successful stock investing:
· Pick a company that has strong fundamentals, including signs such as rising sales and earnings and low debt. (See Chapter 11.)
· Make sure that the company is in a growing industry. (See Chapter 13.)
· Fully participate in stocks that are benefiting from bullish market developments in the general economy. (See Chapter 15.)
· During a bear market or in bearish trends, switch more of your money out of growth stocks (such as technology) and into defensive stocks (such as utilities).
· Monitor your stocks. Hold on to stocks that continue to have growth potential, and sell those stocks with declining prospects.