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| The Basics | 10 growth stocks that can't be stopped
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Worried that oil or interest rates will knock the recovery for a loop? Here's a screen that will help you pick growth stocks that will weather whatever the economy offers -- and the latest candidates.
By Harry Domash
The economy still looks like it's gaining strength, but there's no shortage of naysayers who point to rising oil prices and interest rates, and a falling dollar as evidence that the recovery could falter.
So what's an investor to do? In my view, this is no time to give up on growth. Instead, you should seek out those fast-growing companies that will keep up their pace regardless of which economic prognosis proves true.
With that in mind, here's a screen seeking strong companies that fit that bill. Consider it a growth screen for all seasons.
You can click here to run the screen with my settings, or you can modify it to suit your needs.
Let me show how it works, first with an explanation of what I mean by an all-season growth stock.
Seeking growth, now and later
A stock isn't a growth stock unless it's growing both sales and earnings. For our requirements, we need especially strong growth in both departments. By that I mean at least 20% year-over-year growth.
You can screen for historical earnings growth, but reported earnings are often distorted by one-time or non-recurring charges, such as when companies make acquisitions. So I use Wall Street analysts' earnings growth forecasts, which usually ignore non-recurring charges.
I screen for both the current and next fiscal year's growth forecasts, to assure that the forecast growth is sustainable and not due to a one-time event such as the sale of a subsidiary or an income-tax credit.
Screening Parameter: Current Year Growth Rate >= 20
Screening Parameter: Earnings Per Share Growth Next Year >= 20
You can increase the minimum annual earnings growth requirements to 25% if you want to focus on the fastest growers, but I don't advise going above 25%, as higher forecasts are seldom achieved.
There is no screening parameter for forecast revenue growth, but it doesn't matter. Revenues aren't affected by non-recurring charges that distort historical earnings. I've specified 20% minimum trailing 12-month revenue growth. But if you increase the earnings-growth requirements, change the sales-growth requirement accordingly.
Screening Parameter: Revenue Growth Year vs. Year >= 20
Now that we've defined the growth-stock universe, we'll add search elements to find the best prospects, starting with profitability.
A better way to measure profits
Earnings per share gets the attention at quarterly report time, but it's better to focus on other profitability measures. Here's why.
Say two companies both earned $1 million, but company A did it on a $10 million investment (in the form of shareholders' equity), while company B's shareholders had to ante up $50 million to get the same profit. Clearly, company A's shareholders are getting more bang for their bucks.
There are other measures, but return on equity (net income dividend by shareholders' equity) is the most widely used profitability yardstick because of one unique attribute. If you do the math, you'll find that a company cannot grow earnings faster than its ROE without raising additional cash.
Here's what I mean: A company with a 15% ROE cannot grow earnings faster than 15% annually without borrowing funds or selling more shares. Of course companies often do raise funds by selling shares or borrowing, but at a cost. Paying interest on the added debt eats into earnings, and selling more shares shrinks earnings per share.
Thus ROE is, in effect, a speed limit on a company's growth rate. Many pros that I've talked to require a 15% minimum ROE, and I adopted that value for my all-seasons screen.
Try increasing the minimum to 20% if your screen turns up too many hits. When it comes to ROE, higher is better, within reason.
Screening Parameter: Return on Equity >=15%
Avoid the burden of big debts
If the economy does strengthen, interest rates will continue to rise. Companies burdened by outsize debts will see their profit margins pressured because their debt-servicing costs will rise with interest rates.
The debt-to-equity ratio (long-term debt divided by shareholders equity) is a widely used debt measure. But the definition of high debt varies by industry. Automakers, for instance, typically carry more debt than software companies.
So, rather than setting an arbitrary maximum, I require that qualifying stocks' D/E ratios not exceed their industry average.
Screening Parameter: Debt to Equity Ratio <= Industry Average D/E
If you prefer to avoid high-debt stocks, regardless of industry, use this parameter instead.
Screening Parameter: Debt to Equity Ratio <= 0.2
At what price sales?
The price-to-earnings ratio is the best-known valuation gauge. But P/E can be misleading for the same reasons mentioned in the earnings-growth section. That is, one-time charges can reduce reported earnings, making the P/E unrealistically high.
The price-to-sales (P/S) ratio is similar to P/E, except it compares the recent share price to 12-months' per-share sales instead of earnings. Since sales don't fluctuate as much as earnings, P/S is a more reliable value measure.
Reasonably priced growth stocks usually trade with P/S ratios in the 3 to 8 range. P/S ratios below 3 signal value stocks. Avoid stocks with P/S ratios of 9 or higher, because, at least in my view, their share prices already reflect all possible good news.
Thus, I set the maximum P/S at 8. If you are particularly risk averse, reduce the limit to 6. Increase it to 12 if you want to be more speculative.
Screening Parameter: Price/Sales Ratio <= 8
Piggyback on the big boys' research
Mutual funds, pension plans and other institutional players buy lots of growth stocks. So scant institutional ownership means the big boys saw something that they didn't like.
So there's no point in buying stocks the institutional money managers don't want. Institutional ownership (percentage of outstanding shares) typically ranges from 40% to 90% for in-favor growth stocks. I allowed some extra leeway and required 35% minimum institutional ownership.
Screening Parameter: % Institutional Ownership >= 35%.
Reduce the minimum to 25% if you want to walk on the wild side.
With growth, bigger is safer
Most investors use market capitalization (recent share price multiplied by number of shares outstanding) to define company size.
Once you get below a certain market capitalization (say, $1 billion), the lower the market cap, the riskier the stock. That's because smaller companies typically have only a narrow product line, which is often targeted to a single industry sector. A downturn in that industry would sink sales and earnings, and probably clobber the share price.
By contrast, bigger companies usually have diversified product lines serving multiple industries.
I set my minimum market cap at $500 million, which eliminates the riskiest stocks. If you're a risk-taker, reduce the minimum down to $250 million. Conversely, reduce your risk by increasing the minimum to $2 billion if you're investing serious money that you'll need for retirement.
Screening Parameter: Market Capitalization >= 500,000
Avoid controversy, short sellers
Some of the best growth candidates are stocks the market loves. It's that wonderful exuberance that propels share prices ever higher. Thus, the last thing you want in a growth candidate is controversy. The short-interest ratio (number of shares sold short divided by the average daily trading volume) is a great tool for measuring that aspect of market sentiment.
Short interest ratios of 10 or more tell you that many investors think the stock is more likely to go down than up. Even if their reasoning is flawed, the controversy will hold down the share price anyhow.
I set my maximum allowable short interest ratio at 9 to rule out such stocks. But there's nothing magic about that number. If you want to reduce your risk further, cut the limit to 5 or 6.
Screening Parameter: Short Interest Ratio <= 9
A surprise may be no reason to party
Surprises are the difference between the analysts' forecasts and the quarterly earnings number that a firm actually reports. Negative surprises (reported earnings below forecasts) usually sink the share price, and some experts believe that one negative surprise foretells another. Why take a chance? I avoid such stocks by requiring that the most recent surprise be zero or a positive number.
Screening Parameter: Recent Qtr. Surprise % >= 0
Strong price chart required
Sometimes, all the numbers look good but privy stockholders are unloading their shares because they've heard bad news that hasn't yet been made public. In these cases, a faltering price chart is a good clue that something is going wrong.
Growth stocks should be in uptrends, meaning that shares are trading above both their 50-day and 200-day moving averages.
Screening Parameter: Last price > 50-Day Moving Average
Screening Parameter: Last price > 200-Day Moving Average
Only 10 stocks met my all-seasons requirements when I ran the screen.
| All-season growth stocks | | Company | Previous day's closing price | Industry name | | LCA-Vision (LCAV, news, msgs) | $28.73 | Medical practitioners | | Berry Petroleum (BRY, news, msgs) | $62.78 | Independent oil & gas | | FMC Technologies (FTI, news, msgs) | $34.16 | Oil & gas equipment & services | | Aeropostale (ARO, news, msgs) | $33.49 | Apparel stores | | Urban Outfitters (URBN, news, msgs) | $47.52 | Apparel stores | | Quality Systems (QSII, news, msgs) | $91.42 | Health-care information services | | Navigant Consulting (NCI, news, msgs) | $25.59 | Management services | | Panera Bread (PNRA, news, msgs) | $53.61 | Specialty eateries | | Knight Transportation (KNX, news, msgs) | $27.75 | Trucking | | USANA Health Sciences (USNA, news, msgs) | $43.00 | Drug-related products |
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No matter how well thought out the screen, consider the results a list of candidates to research, not a buy list.
At publication time, Harry Domash did not own or control any of the stocks mentioned in this column.
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