Fundamental Traits of Superior Growth Stocks

Last week, I wrote about some of my favorite stocks and mutual funds for generating dividend income in retirement. For many retirees, there is no better feeling than watching their dividend payments grow over time to keep pace with inflation.

But if you are still gainfully employed, dividend payments may be unnecessary and inefficient. There is no good reason to pay taxes now on income that won’t need until later.

This week, I am going to focus on the growth side of the total return equation. In many cases, the potential gain from capital appreciation far exceeds a stock’s dividend payment.

Especially now, given Wall Street’s clear preference for momentum stocks. In August, the companies in the “pure growth” component of the S&P 500 Index ranked first out of the 17 sub-categories of the index with a gain of 5.1%.

The next two best-performing groups were “momentum” and “growth” stocks, up 4.5% and 4.2%, respectively. And the worst-performing group in August? It was “low-volatility, high-dividend” stocks with a gain of 1.5%.

Those recent trends won’t last forever. Eventually, a change in market sentiment will reshuffle the deck and a new category king will emerge.

But for now, growth stocks are where the action is and that may remain the case well into next year. If you don’t already have a method for identifying promising growth companies, here are some key metrics that correlate highly with stock market winners.

PEG Ratio

Peter Lynch popularized the use of the PEG (price/earnings-to-growth rate) Ratio to identify GAARP (growth at a reasonable price) stocks for the Fidelity Magellan Fund (FMAGX). During his 13 year tenure, the average annual return for the fund was 29%. To calculate a PEG ratio, divide a company’s trailing 12-month price-to-earnings per share ratio into the average growth rate of its earnings per share over the past few years.

Lynch believed that the price-to-earnings (P/E) ratio for a company was not sufficient to judge how cheap or expensive it is. A high P/E ratio is fine provided the company is growing its earnings faster than the average stock.

Back then, a PEG ratio of less than 1.0 was considered attractive for a growth stock. These days, a PEG ratio of no more than 2.0 is acceptable for companies in high-growth sectors of the economy. Wall Street no longer cares about dividends so it is willing to pay a premium for growth.

Return on Equity

Many companies, especially in the tech sector, pay no dividend at all. They’d rather use that excess cash flow to invest in the growth of the business.

That’s okay, provided that money is being invested wisely. Return on equity (ROE) can tell you how effectively that money is being spent. To calculate ROE, divide a company’s net income into its shareholders’ equity.

The higher the ROE, the more bang for the buck a company is getting out of its excess cash flow. For growth stocks, an ROE of at least 10% is considered necessary to justify not using that money to pay dividends or repurchase stock.

EPS Growth Rate

Arguably, the single most important trait of a growth stock is to be able to grow its earnings per share (EPS) at a faster pace than the overall market. As a stockholder, that number represents your share of the company’s bottom-line performance.

Sometimes the EPS growth rate rises because the company is becoming increasingly profitable. Conversely, it can also go up if a company reduces the number of shares outstanding even if profitability remains unchanged.

Either way, an EPS Growth Rate of at least 25% indicates that a company is on the upswing. Combined with the other two metrics above, a company that meets all three of these thresholds should appreciate more than the overall stock market.

Believe it or not, more than 100 stocks that trade on a U.S. exchange met or exceeded all three thresholds last week. But if we tighten up the requirements to a PEG ratio of less than 1.0, ROE of at least 20%, and an EPS Growth Rate of greater than 50% during the previous twelve months, only 27 companies still make the cut.

At that point, you should examine a variety of technical indicators to determine if a stock appears to be on the verge of breaking out to the upside. I don’t have space to go into that today, so that will be the subject of my next article later this week.

You should know, I’ve created a tool that lets me pinpoint lightning quick profit opportunities, more often. One that I believe is unlike anything else you’ve ever seen. It’s also a tool that won’t be available to anyone else. Not even existing Personal Finance subscribers. You see, I’ll only be sharing these trades inside my new advisory, Personal Finance PRO. Watch this space for details.