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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