Thursday, 15 April 2010

Growth Investing: The importance of track record of Sales and Earnings

The most important driver of growth in stock price is growth in earnings.  Future earnings growth frequently depends on past earnings growth.

To convince yourself that you must look at the track record, companies that have had positive results for a while are likely to exhibit that kind of performance for years to come, especially when the management team remains in place.  Once in a while, this may not work, but on average you will come out a winner if you play the game by emphasizing a company's track record of earnings.

A short record of, say, less than five years is probably a dangerous way to identify the future growth of a company.  It is important to focus on a longer time span.  Great growth companies remain outstanding for many years after their initial spurt in growth.

Unless you know a lot about the company, it is best to avoid initial public offerings (IPOs).  The average three-year post-IPO performance is 20 percent below the corresponding market returns.  While IPOs are often marketed as growth stocks, their long-run performance has been dismal.  Generally speaking, IPOs are anything but growth stocks.

Growth in earnings does, however, depend on growth in sales, especially in the long run.  The customer is the main driver for growth in sales.  In general, it is best to keep both sales and earnings in mind when thinking about growth investing, not just one or the other.

One good approach to finding growth stocks is to identify some great products and services, as Peter Lynch has often emphasized.  Still, you must ask several questions before you actually buy stock in such companies.

Here are some qualitative questions that you should take time to ask and answer before you decide to invest in a growth stock.

Is there potential to grow sales and earnings for several years?
How are relations with employees?
Is research and development important?
How does the company respond to challenges?
Is management quality excellent?
How important are profit margins?
What is the company's Achilles' heel?

You can afford to take your time.  Great companies will give you returns of several hundred percent, and if you miss some of it in the beginning, you should still do well.

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