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. 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 quality 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 quality 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 $240 a share, or Commonwealth Bank, which listed in 1993 first at $9.35 a share and now trades close to $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. In our view, the best quality growth stocks are the ones that keep rising sustainably based on strong fundamentals. If a share price disconnects from the quality of the underlying business, this may result in short-term gains. However, in the long run, the price will eventually revert to the fundamentals.
So what should you really be looking for in identifying a quality growth 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.
At Lincoln, we define a quality growth stock using three very important rules. The very best stocks become our Star Growth 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 these 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 enough for a stock to be healthy for solely one period.
Past Financial Performance: For growth stocks, Lincoln uses a range of different factors to identify companies that meet key underlying quality growth factors. Put simply, to suit the needs of a growth investor, a company must possess a consistent history of generating efficient profits with strong cash flow generation.
Outlook and active risks: To determine whether a company’s fundamental performance is sustainable, investors must analyse the company’s outlook and active risks. For growth opportunities, we want to gauge whether a company is likely to remain as a Star Growth Stock in the future, which includes an assessment of a company’s active risks to help ascertain the likelihood that it will retain its quality elements.
Different approaches to achieve capital growth
Though investors seeking capital growth are after the same outcome, there are some distinct approaches to portfolio construction and optimisation that we educate our members on. At Stock Doctor we provide five defined strategies, utilising our Star Growth Stocks, which ensures the portfolio is managed using quality companies who as a collective have yielded strong returns for investors historically.
Which specific strategy you wish to employ will be the one that you feel most comfortable implementing. The five strategies around holding Star Growth Stocks are:
- Ongoing rebalance of the Star Stock portfolio
- Letting stocks rise and fall
- Stock specific management
- Holding Star Growth Stocks that pass SD30TSR
- Holding Star Growth Stocks that pass SDMAX
First, an ongoing total rebalance of the Star Stock portfolio is where an investor holds all the Star Growth Stocks and rebalances the portfolio on an event such as a stock entering or exiting the Star Growth Stock portfolio.
Next is to hold the Star Growth Stocks, however, without the need to rebalance, letting your profits run and the occasional stock fall, with decisions to be made only when a Star Stock rating is changed.
The third strategy builds on strategy two where you hold the Star Growth Stocks. However, implement a well-documented, stock-specific management strategy around taking profits to build a future cash pool for new investments and seize opportunities when price volatility strikes in quality businesses. This is the method that Lincoln’s Australian Growth Fund employs.
The next two strategies utilise two technical indicators identified by Lincoln Indicators through rigorous backtesting as working on a base of quality Star Growth Stocks.
Holding the Star Growth Stocks that pass the SD30TSR indicator which is a 30% stop loss level is strategy four and holding Star Growth Stocks that pass our SDMAX moving crossover indicators is strategy five.
They are to be employed by investors who are sensitive to price drawdowns and wish to avoid catastrophic declines without needlessly being stopped out of a quality business when normal price volatility occurs.
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 and can make decisions with discipline 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.
- Have an investing framework to make confident and informed investment decisions with discipline based on your investment objective and tolerance to risk.
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 Funds, please contact us on 1300 676 333.