Indicators of great growth stocks include:
- A high return on equity indicates a strong competitive advantage due to factors such as low cost production, a monopoly on the market or strong barriers to entry.
- Historical sales growth, specifically growth rates higher than the nominal GDP over three to five years, proves sustainable earnings.
- Examining interest cover helps identify businesses that can deliver a high return on equity without incurring excessive borrowings.
Whilst the market environment can be volatile, there is still ample opportunity to find growth stocks ideally positioned to deliver solid investment returns.
In the Netwealth webinar ‘How to find and invest in ASX growth companies’ hosted by Hyperion Asset Management’s Managing Director Tim Samway, he outlined how to identify these growth stocks using an evaluation method that has seen them create successful investment portfolios for clients over the past two decades.
According to Tim, demographic factors such as the old age dependency ratio should see the current low growth market environment persist over the next 5-10 years.
This means being able to identify good growth stocks becomes even more imperative when trying to build a strong investment portfolio that delivers real returns for clients.
“The last 10 years has been somewhat of a forgotten decade. In fact, earnings of the Australian market have not exceeded levels experienced since before the GFC. And with real growth of earnings expected to be muted, finding quality growth businesses that can be held for long periods of time to enable you to extract the price increase that comes from increased earnings is essential.”
There are two main criteria for evaluating growth, which help to establish whether a business is truly able to deliver sustained growth and earnings, thereby proving its value as a growth stock.
The first is the ability to grow their ‘slice of the pie.’ Is the business able to beat competitors, build market share and consequently, profit over the long-term? The second is expanding the addressable market or ‘growing the pie’. This looks at whether a business can expand into new and additional markets once they have dominated their original market space.
When evaluating the nature of growth, it’s important to be wary of businesses that can grow via acquisition as this creates the risk of unsuccessful integration, or businesses whose performance is tied with market movements and those who have experienced rapid growth but are yet to prove their earnings are sustainable.
According to Tim, once sustainability has been established, there are three main metrics that should ideally be applied when selecting good quality growth stocks.
“A high return on equity is a terrific marker as it often represents a strong competitive advantage created due to factors such as low cost production, a monopoly on the market or strong barriers to entry. Secondly, historical sales growth, specifically growth rates higher than the nominal GDP over three to five years is another important measure of a quality growth stock as it helps to prove sustainable earnings. And thirdly, examining interest cover is an important metric as it enables you to identify businesses that can deliver a high return on equity without incurring excessive borrowings.”
An example of a good growth stock is Amazon. Whilst not in Australia yet, this is a stock that cannot be ignored. With an unbelievably strong competitive advantage due to its compelling customer value proposition of convenience, value for money and choice, plus its ability to grow the addressable market via additional offerings from new products to cloud computing and more, this is a stock that ticks every box when establishing its value as a growth stock.
“Currently Amazon has a huge proportion of the online market, particularly in the US where it holds over 30% of the online market. However, to date they only have 3% of the total retail market, meaning the scope for growth and therefore earnings, is huge due to the consistently increasing trend of online shopping,” said Tim.
Closer to home, REA (realestate.com.au), Dominos and Seek are three examples of good quality growth stocks on the ASX.
“Whilst in different sectors, these three businesses all leverage technological innovation to deliver a solid customer value proposition to their markets. From extensive and well-priced property listings, to the ability to track your pizza delivery in real time through to the development of the optimum online platform for employers and placement agents, these three businesses go above and beyond their competitors to ensure leading-edge customer service,” said Tim.
Their consistent innovation, supported by their ability to grow via expansion both on a domestic and international basis, and current track record of earnings, prove their investment value as a growth stock.
According to Tim. “This investment approach over the past 20 years has seen returns that average 4.5% per annum, proving that there are valuable growth opportunities to be found in a somewhat mild market. You just have to use the right metrics and criteria to cut through the negative noise.”
To hear the full presentation, ‘How to find and invest in ASX growth companies click here or if you would like to speak to a member of the Netwealth team please contact us.