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Growth stocks like Microsoft (MSFT), Google (GOOG), and Amazon (AMZN) have rewarded their investors with a staggering 25% annualized return on their investments since their listing.
Growth stocks are the kind of stocks that have the potential to outperform the market on a continuous basis. Such stocks are the ultimate dream of any long-term investor who wants to beat the returns of the S&P 500.
But only a few selected companies have managed to beat the market in the long-run. Most of the stocks on wall street have underperformed, and a lot of them have given a negative return too.
So finding the next growth stock is not a cakewalk. It requires some effort and some analysis from your side.
To make your job easy, we’ve got Jeremy Deal with us from JDP Capital Management. Jeremy is the founder and portfolio manager of his fund and runs the fund on the ideology of long-term growth by investing in companies that can survive and thrive in the long-run.
He is going to share with us the four characteristics that the best-performing companies have in common and how he picks the best growth stocks for his own fund.
Value Stocks vs Growth Stocks
A lot of people seem to confuse value investing with growth investing, but they are not the same. There are some significant differences between the two that need to be addressed before moving forward.
Value investing, in a nutshell, is investing in great companies at a discounted price. On the other hand, growth investing is investing in stocks that have the potential to grow your portfolio at a faster rate than S&P 500.
In value investing, we focus on the price of the equity and try to find stocks that are undervalued, while growth stocks that continuously beat the market returns generally trade at a premium, meaning they tend to be expensive.
Another big difference between value and growth stocks is that value stocks generally pay a dividend while growth stocks seem to reinvest all their earnings back into the business. A prime example of this is GOOG and AMZN, who never pay a dividend despite being cash-rich companies.
So now that we understand the difference between value and growth stocks, it’s time to learn how to pick the best growth stocks for your portfolio.
Characteristics of the Best Growth Stocks
An interesting study that Jeremy share is if you look at the two major market peaks in 2000 and 2008 before the two major crashes, the S&P 500 didn’t give any return from one peak to another. That means if you bought at the peak in 2000, the best you could’ve got after holding for nearly 8 years is break-even on your investment.
But during the same period, if you look at some of the growth stocks, they’ve outperformed the market by 2 to 3 times and gave investors great returns even if they bought during the peak of the dot-com bubble.
Now, what’s remarkable is that these growth companies seemingly had nothing in common in terms of sector, market cap, or how long they’ve been in business.
But when you dive deep and conduct a study on them, you’ll find four commonalities or characteristics they share.
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1. A Business Model Adaptable and Relevant to Tomorrow’s Economy
The economy, especially in the current scenario, is changing rapidly. The Covid situation caused a lot of businesses that were unadaptable to the new normal to shut down. Many businesses had to shift their business models.
But what’s even more remarkable is businesses with the most futuristic technology not only survived but boomed during the period and posted high growth.
All this shows that in the long-run, only the businesses with high adaptability and relevancy to tomorrow’s economy will survive and thrive.
Now, a company of the future doesn’t necessarily mean a tech company, like the popular belief. You can find companies that are relevant to tomorrow’s economy that is not a SaaS or software business.
“Generally speaking, technology just refers to a company that is on the cutting edge and is able to grow through creating efficiency or cutting costs out of the system in any sector,” says Jeremy.
And he is absolutely correct because tomorrow’s economy doesn’t mean that brick and mortar businesses or old economy companies will cease to exist.
Still, as a fund, Jeremy is tech-heavy and switched a lot of his fund’s portfolio towards tech stocks after Covid because they have to beat the S&P 500 returns.
2. Durable Pricing Power Protected by Growing Competitive Advantage
The second most important thing is durable pricing power. The pricing power of a company is its ability to increase the product or service prices without it having an adverse impact on their demand or sales. Durable pricing power refers to the ability to keep raising prices for a long period of time.
A company can’t keep increasing its prices if that is not backed by a competitive advantage. And to ensure the durability of pricing power, a company must have a competitive advantage that is regularly growing.
That is why pricing power is one of Warren Buffet’s favorite indicators to screen out companies for his portfolio.
So if you’re looking for companies that will be able to sustain and grow themselves in the long-run, then durable pricing power protected by growing competitive advantage is one critical point to consider.
3. Capital Allocation and Balance Sheet Strategy
The third thing is capital allocation and balance sheet strategy that supports the company’s moat. A company’s capital allocation strategy is how and on what things a company spends its treasury.
Whether the company is asset-light, asset-heavy, paying dividends, or re-investing in growth. Whatever it is, it must support the company’s moat and support its competitive advantage so that the pricing power of the company keeps growing.
Proper capital allocation skills of Jeff Bezos are accredited for much of Amazon’s success. Any company with a poor capital allocation is bound to fail in the long-term. That’s why it is your job as an investor to choose a company with the best capital allocation strategy that supports its growth in the long-run.
4. Strong Alignment of Interest Between Management and Equity Holders
It is one of the most important things that Jeremy looks for. For their own fund, he prefers companies that have really strong insider ownership like Spotify, where the founders have a very thick skin in the game.
Strong insider ownership signals high confidence for the future growth of the company and also shows the management’s commitment towards growth.
As an investor, what we want from the management is to maximize the shareholder’s return, and they will do it best if a lot of their own net worth depends upon it.
So a strong alignment of interest between management and equity holders is the fourth and last characteristic of a high growth company.
Those were the four common characteristics of a growth stock. Now, it’s time for you to do some research and find out which are some of the listed companies that tick all or most of the boxes. If you find some, add them to your portfolio and watch them beat the S&P.