The aim of investors should be to capture most value by buying stocks where there is visible, forward earnings growth and where this growth can be bought at a reasonable price.
A disciplined approach to stock-picking
Growth stocks
Essentially investors should seek to identify shares that are ripe for a status change i.e. ones that are likely to be re-rated in the near future. Without industry-specific knowledge, initially this is best done by employing stock-screening filters.
One of the most useful search criteria for identifying growth stocks is called the Price Earnings Growth Ratio or PEG, which is used to avoid overpaying for future earnings growth.
For example, an attractive PEG of 0.5 would be calculated by dividing a company’s price-earnings ratio (PER) or multiple of earnings, of say 10, by its forecast growth rate in earnings per share (EPS), of say 20. In other words, the company’s forecast growth in earnings per share is twice that of the multiple of earnings awarded to it by the market. The higher the multiple of earnings, the higher market’s expectations are for growth.
When searching for growth shares one useful strategy to employ is to combine multiple criteria. For example, you could search for stocks with a low PER in relation to their growth rates, above average EPS growth (say over 20%) and strong cash flow per share in relation to EPS, which helps eliminate creative accounting.
Assuming one’s analysis is correct and the company grows its earnings consistently at, say, 20% per annum, all other things being equal, the stock selection should at least maintain its rating and its share price should rise by a corresponding 20%.
However, investors’ expectations of the growth prospects for a consistent growth share often increase over time and a higher multiple is likely to be awarded by the market. A re-rating, for example, from eight times earnings to 12 times would have a more dramatic effect and produce an additional 50% increase in the share price.
It is important to note that it is the change in investors’ perception of a company that often results in greater wealth creation than the actual financial results themselves.
Positive earnings surprises are normally triggered as a result of ‘something new’, examples of which include earnings enhancing acquisitions, positive structural, demographic or legislative change, new discoveries, the introduction of disruptive technology, new product cycles etc…
Deep value
Another example of where a lot of value can be created occurs during an economic downturn or recession. This is usually created by the indiscriminate mark-down of stocks, both good and bad, as over-leveraged investors and funds are forced to sell their holdings.
Those stocks that are marked down in price but which defy the downturn and continue to increase their earnings can become seriously undervalued. If a company’s shares are marked down indiscriminately in this way ‘deep value’ is likely to emerge.
Early warning radar
Investors can also usefully search for company-specific opportunities within a sector or industry.
Share price drivers that act as a kind of early warning radar and that can sometimes indicate a possible re-rating is on the cards include: the introduction of new management, significant cluster buying of shares by directors, consensus forecast profit upgrades by brokers, a particularly upbeat Chairman’s outlook or trading statement, significant new contract wins etc…
This bottom-up approach is facilitated by the investor possessing good industry knowledge and scuttle-butting i.e. getting out there and ‘kicking the tyres’.
Other attractive attributes giving revenue and earnings visibility and which help to underpin brokers’ forecasts are long-term contracts with growing order books stretching years ahead and recurring revenues, such as maintenance and support.
