Buying into a company’s growth story can be financially rewarding. Here’s what to look for.
In this article, Lincoln Indicators discusses:
- The strategy behind investing in shares on the ASX that have a growth bias.
- Why fundamental analysis is key for DIY share investing generally, including when seeking out growth stocks on the Australian stock exchange.
- The different approaches to identifying growth stocks
- How stock research tools and good share market research are critical to overall share market success.
Whether you’re a DIY share investor with direct shares in your own name, through a self managed super fund (SMSF) or via a professionally managed fund, investing in shares on the Australian stock exchange is almost always about buying into a company’s growth story.
After all, the effective aim of the game as an Australian share market investor is to buy into a stock that will increase its share price over time, hopefully significantly. That’s often the case even if part of your broader investment motivation is also around longer-term income generation.
Generally speaking, there are two broad categories of shares for investors to consider on the Australian Securities Exchange (ASX). These are the growth stocks (those companies that investors expect will increase in capital value over time) and income stocks (those that are more likely to generate a reliable and tax-effective income stream through fully franked dividends (also see How to find a great income stock). Sometimes a company will fit into both categories, but growth stocks often pay a lower-than-average dividend, preferring to reinvest their profits. Sometimes growth stocks trade on a higher price earnings ratio (PE), as investors pay a little more today for the expected profits of tomorrow.
Of course, all investors need to avoid the stocks that are financially unhealthy and will neither grow nor generate dividend income. These stocks, many of which are small caps and micro caps, are usually a recipe for financial disaster.
Why fundamental analysis is key
Whether your focus is on growth or income, finding the best shares to buy is always key. And that can only really be done through detailed fundamental analysis, using stock market research tools such as Stock Doctor. It is only through fundamental analysis that investors can determine the true financial health of the company they are investing in.
There have been many examples of companies on the ASX that have achieved enormous share price growth over time, some doubling, quadrupling or going up tenfold or more. Think of blood products group CSL Limited, which listed in 1994 on a post dilution basis at $0.76 a share and now trades above $90 a share, or Commonwealth Bank, which listed in 1993 first at $9.35 a share and now trades above $80.
Equally, there are countless examples of companies that have risen meteorically, only to come crashing back to Earth in spectacular fashion. Probably the most famous Australian example of this was nickel miner Poseidon NL in the late 1960s, whose share price soared from 80 cents to $280 in less than six months, and subsequently collapsed as nickel prices fell and the company ran into operational problems. The Poseidon story was a painful lesson that a company’s underlying growth story must match up with reality. Fundamental analysis, using financial ratios to filter the good stocks from the bad, is key.
While some investors can achieve great returns along the way, others can lose miserably. The best growth stocks are the ones that keep rising, based on strong fundamentals. If a share price disconnects from the quality of the underlying business, this may results in short-term gains. However, over the long run, the price will eventually revert to the fundamentals.
So what should you really be looking for in identifying a quality stock that should deliver sold price appreciation over time?
Generally speaking, growth companies are characterised by strong earnings forecasts that are above-average relative to the broader market. Investors target these companies because they expect them to be bigger tomorrow than they are today, and this increases the stock’s intrinsic value.
At Lincoln, we define a quality growth stock using three very important rules. The very best stocks become our Star Stocks, which have consistently outperformed the market over time.
The three Golden Rules for Growth stock selection
- Financial Health: is the company exposed to manageable risks? To meet this criteria a stock must exhibit Strong or Satisfactory Financial Health A company must be healthy for at least two consecutive periods or more. It is not sufficient for a stock to be healthy for solely one period.
- Management Assessment: For Growth stocks, Lincoln uses Return on Assets (ROA), Return on Equity (ROE), Earnings per Share (EPS) growth and revenue growth to asses a stock and measures these criteria based on the company’s market capitalisation and the industry it operates within. In order to suit the needs of a growth investor a company, must possess a consistent history of efficient profit growth.
- Outlook and forecast: To determine whether a company’s fundamental performance is sustainable, investors must analyse the company’s outlook and forecast performance. For growth opportunities, we want to gauge whether a company is likely to remain as a Star Growth Stock in the future. For Star Growth Stocks and Borderline Star Growth Stocks we provide our estimates for the company’s underlying performance in the coming year.
Different approaches to achieve Capital Growth
Though investors seeking Capital Growth are after the same outcome there are two distinct approaches that can help identify these opportunities.
- Value Investing: A value investor will look for companies trading at a discount to their intrinsic value. Though a company may be good, unless it represents value they are not willing to pay above the odds for a company. To learn more about the value investing approach read this article.
- Growth Investing: A growth investor is primarily focused on identifying companies that are expected to be bigger tomorrow than what they are today. This can mean that a growth investor will be willing to pay a premium price for a company with strong prospects. To learn more about growth investing read this article.
Why stock research tools are important
Investing for growth can be rewarding, and a lot comes down to individual risk appetite. Those willing and able to do proper fundamental company analysis stand a much higher chance of making it all pay off. On the other hand, those who invest blindly – whether they’re looking for growth or income – are destined for failure.
Sophisticated stock research tools such as Stock Doctor, which accurately measures financial health and provides quantitative and qualitative research on every ASX-listed company, takes the hard work out of fundamental analysis.
With Stock Doctor, you can:
- Through our Star Growth Stocks identify the best-performing growth companies on the ASX with outstanding proven performance.
- Access easily the Financial Health and the other two Golden Rules for Growth stock selection of every company.
- View the forecasts and outlook of over 500 companies to help assess whether a company is a growth opportunity
Our team is always here to help you identify the best Growth Stocks on the exchange. If you would like to discuss this article in more detail or would like more information on Stock Doctor or our Managed Investment Solutions, please contact us on 1300 676 333.