Out of the thousands of companies in the investing universe, why are growth companies superior? Isn't investing in just about any company a gamble that may or may not pay off?
Growth companies are the best place for your investing dollars for a number of reasons. The most important is that a company's stock price eventually follows its sales and earnings growth.
Purchase the stock of a company with strong, consistent sales and earnings growth selling at a reasonable price, and hold it for the long term. Over time, that company's stock price will rise along with its sales and earnings, helping you meet your wealth-building needs.
This is why not just any company will do. Successful investing involves linking your fortunes with those of the best businesses that this country has to offer.
It's much less likely to work when you invest in penny stocks, a hot tip from a broker, or the latest technology fad. Stick with the proven strategy of investing in leading growth companies for the long term.
How do you find superior growth companies? These companies demonstrate consistent, strong long-term growth in sales and earnings.
Sales are what a company produces or markets, whether it is a good or service. McDonald's sells fast food. Microsoft sells software and related products.
But just selling a particular good or service and staying in business isn't enough. We set the bar as high as possible, seeking the absolute best that American capitalism has to offer.
We want publicly held companies that continue to increase their sales during a number of years—at least five years, in fact. That's a minimum—the longer the track record is, the better.
Not only that, these companies must retain a good portion of what they sell in the form of earnings per share. Earnings per share are a company's retained profits divided by its shares outstanding after paying expenses and taxes.
Earnings per share must also be steady, showing that a company's management can control the expenses involved in creating goods or services, creating wealth for the company itself and its shareholders.
Why is consistent growth important? Many companies grow in spurts, with high growth years interspersed with slow or even down years.
Again, it comes down to wanting the best place to invest your hard-earned money. The market prizes consistent growth over inconsistent growth.
Only the best companies with top-notch management can deliver consistent growth at competitive rates year after year. For large companies with sales in excess of $5 billion a year, seek growth of between 7% and 12% a year in both sales and earnings.
Set the bar higher for smaller companies. Look for medium-sized companies with sales between $500 million and $5 billion a year to grow on average between 12% and 15% a year. For small companies with sales less than $500 million a year, you'll want growth at 15% or more each year.
These are broad guidelines, as growth rates vary by industry and depend on many factors, including the state of the overall U.S. economy. Even the strongest company may experience a slowdown due to factors beyond its control. But the overall trend should, again, be positive and consistent.
Once you've identified a growth company, there is one more important factor to consider before buying shares of its stock. You must determine whether that company is selling at a reasonable price.
Growth, however important, isn't enough in and of itself. Many investors in technology stocks found this out during the stock market bubble of the late 1990s.
In an effort to capitalize on the seemingly limitless growth potential of technology stocks, investors threw caution to the winds and paid up for the stocks of high-growth companies such as Cisco (NASDAQ:CSCO) and Microsoft (NASDAQ:MSFT).
As the 1990s rolled on, the stocks of such companies rose higher and higher. Investors came to believe that no matter how high they rose, they would continue to climb even further.
The rest is history. Even the technology giants couldn't sustain their growth when the economy went into a recession and was further buffeted by terrorist attacks and war. Stock prices fell, with technology stock indexes dropping more than 75% off their highs at the lowest point of the bear market.
This hard lesson showed investors that a company's stock price is important and that even the best growth story has its limits. In a later article, we'll examine the relationship between a company's stock price and its earnings, known as the price-to-earnings (P/E) ratio.
A company's P/E is a telling indication of how the market values a particular company. By examining a company's past and projected growth rates and P/E ratios, you can arrive at a fairly accurate assessment of what a company's stock price is worth today.
Don't forget that stock prices fluctuate. Those who continued to invest during the bear market of 2000 to 2002 found out that the market doesn't always immediately reward even the best growth story.
Just as the market can overvalue growth companies, it can also undervalue them in the short term. And the short term can last for a couple of years either on the upside or the downside.
If you invest in a growth company at a good price, as long as the company continues to perform well, hang on even if the stock price stagnates or even declines. Eventually your patience will be rewarded.
The rewards may come slowly during a number of years or quickly as a company's stock price jumps when investors suddenly perceive its true value. Keep in mind that the overall goal for your growth stock portfolio is to double your money in five years.
By owning the shares of top-notch growth companies in a variety of sizes and industries, you'll have a much better chance than the average investor of meeting that goal.
This article was originally published by BetterInvesting. Since 1951, BetterInvesting has helped more than five million people become better, more informed investors. BetterInvesting helps its members build wealth through educational webinars, Web-based mutual fund and stock tools, in-person learning events, publications, an active online community, and software. For more information, visit the website or call 877-275-6242.
Neither CUNA nor the author of this article is a registered investment adviser. Readers should seek independent professional advice before making investment decisions.