Thursday, June 28, 2012

Identifying Stock with Growth Potential - Part 2


Today we are holding the next in our series of FREE Wealth Strategies Group seminars. If you want to learn more about improving your investment results, come join us at 2265 Bloor Street West. The event starts with a wine and cheese mixer at 6:30pm. Below is part 2 of an article that ran in Meest Newspaper on the topic of identifying stocks with potential to outperform.


Identifying Stocks With the Best Potential for Outperformance: Part TWO – Looking For GROWTH (for part one of the article click here: Identifying stocks)

This is part two of a two part series on Identifying Stocks with the Best Potential for outperformance. Typically, when sophisticated investors are looking for opportunities in the stock market to acquire stocks that will have a better opportunity to outperform, they tend to look for stocks that are trading cheaply, or stocks that show the best opportunity for growth. Cheapness and growth are two processes for differentiating stocks, and many money managers build their careers based on either structuring their funds based on value (cheapness) or on growth.

In this article we will focus on GROWTH stocks, and look at the determinants that help identify these stocks that are most often used by money managers who adhere to the style of growth investing.

How do you measure growth in a stock? This is a good question, as most often one would think of growth with respect to a stock as the size of the increase in its market value, from a given point in time. This is true, but in general, all stocks are expected to rise in value over time. Those that investors believe will grow the fastest or furthest over time will command a higher premium – be worth more, than those stocks who grow at a moderate pace. Money managers look for stocks that have good growth potential because the market will put a premium valuation on these stocks.   Investors will be willing to pay a higher P/E multiple or P/BV multiple for a stock has a greater growth potential than the average.

In our previous article we wrote about how measures such as P/E and P/BV were used by value managers to determine whether a stock provides value is in the eye of the beholder. With respect to growth stocks, they will most often trade at higher multiples that average run of the mill stocks.  So, growth managers look for specific indicators of a stock’s potential to demonstrate higher growth than average, and then review at what P/E or P/BV multiple the stock trades at, looking to see if the growth is already priced into the stock. 

Just as we saw with the variables that identify a stock’s value relative to the market, there are several variables that investment managers look at when determining whether a stock is a growth stock or not. For our purposes we will focus on three that have worked well in the past.
The first variable we would highlight is Earnings Growth (EG). This variable is one of the strongest quantitative identifiers of a stock that has a high potential to outperform the market. This variable tracks the earnings growth year over year for the past 12 month period. All stocks listed on the stock exchange would be identified, and then each would be ranked according the largest growth in net earnings over the past 12 months (rolling 4 quarters). The 20% of stocks with the highest earnings growth over the past 12 months would be considered the best on this measure, and included in a portfolio. 

In as study of stocks in the S&P 500 Index over a period from 1990 to 2009 (approximately 20 years), this measure had the highest success rate in identifying stocks that would best outperform the market. This was true for periods of a bull market (when equity markets had generated returns of 20% of more from a recent bottom), but when reviewed over the whole 20 year period (bull and bear markets – bears occur when the market falls by 20% or more), this variable was the best relative to 15 different variables tested (“Trading Strategies – Quantitative Variable Review” September 22, 2009, DundeeWealth). 

A second very telling variable that demonstrated success at identifying stocks with a good potential to outperform the market is Sales Growth (SG). Sales growth is measured by reviewing a company’s last 12 months growth in revenues or sales, and those that demonstrate the highest growth would be included in a portfolio. In the same study noted above, this variable ranked second to EG over the 20 year period reviewed, but was best during a bull market period.
Although EG and SG were reviewed only on a last twelve months basis for each company listed in the S&P 500 Index, these variables can be measured on a forward looking basis as well.  

Price / Earnings Ratio to Growth (PEG) – the third variable we’ll discuss here is the PEG ratio.  This measure is very helpful in adding an additional piece of information to the money manager when looking to decide on which stock provides the best growth opportunity. This measure combines a valuation variable with a growth variable. It divides a stock’s P/E ratio with its last twelve months earnings growth profile. In this way, the money manager can identify whether a stock that is demonstrating good growth is actually trading at a reasonable valuation, or whether that growth is already fully priced in. This is the critical measure in determining whether a stock that shows solid growth, in both earnings (EG) as well as in sales (SG), is actually priced like a value stock rather than a growth stock. Often, when looking at the PEG ratio, a stock that is trading with a relatively low P/E may actually be trading at a high PEG ratio, because it is not showing much growth in either earnings or sales. On the other hand, a stock that has a high P/E ratio may actually be quite low on a PEG ratio basis, because its earnings growth is quite high, more than justifying the relatively high P/E ratio.

There are other indicators of growth that professional money managers and sophisticated investors look at when determining whether a stock should command a high multiple and hence rise in value most. We feel that we’ve covered three of those most often used by investors. On June 28th at 6:30pm we will be holding a seminar on how to identify stocks that have the highest potential for outperforming the market, and we will cover these growth indicators, as well as others that are helpful in building a stock portfolio. 

Michael Zienchuk
Manager, Wealth Strategies Group
Ukrainian Credit Union
416-763-5575 x204

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