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In my previous article — 7 Quick Steps to Pick the Best Dividend Stocks — I covered how dividend stocks are great for investors who love to build a portfolio of passive investment income. But we have to admit that not every investor is interested in an income investing approach. Rather, their aim is to invest in growth companies that are able to grow multiple times in value which most dividend stocks can’t achieve. These types of stocks are known as value-growth stocks.
So if you are investing for growth and looking for potential multi-bagger stocks, the question is: How do you pick the best value-growth stocks around?
If you’re slightly lost and looking for some direction, then here are 7 quick steps to pick the best value-growth stocks:
The best value-growth stocks are usually small to mid-cap companies that are in the early stages of their business growth cycle. Unlike stable large-cap stocks which we favour for dividends, these companies are still expanding and have higher growth. Small and mid-cap stocks are also out of favour with many fund managers due to their small size and low liquidity. Because of that, retail investors have the opportunity to own these smaller companies early until they grow large enough for the fund managers to enter the game.
A company that’s still at an early stage of growth should be retaining most of its profits for business expansion. That’s why we prefer a growth company to have a dividend payout ratio of 50% or lower. A company with a high dividend payout ratio is usually a large, mature one where growth has slowed down and most of the profits are returned to shareholders as dividends.
Success always leaves a trail and a growth company should have a track record of tangible growth over the last 3-5 years. We want to look for hard evidence of consistent rising revenues, profits and cash flow to ensure that we don’t get caught up with companies who only sell dreams to gullible investors. Some CEOs and companies love to paint a beautiful growth story to investors how they’re going to enter new markets, expand production capacity and grow customer demand, etc. Amateur investors might buy into whatever the management says hook, line and sinker but seasoned investors will wait for evidence of stable and sustainable growth before investing.
Having a past track record of growth is one thing but whether a company is able to grow further moving forward is another. Some companies might grow well for the first three years and then stop growing thereafter. That’s why it is important to identify companies with many years of growth left in them. To do this, it’s highly important that you study the company’s industry, business model and management team very carefully. Read all their annual reports, attend the AGMs and ask any hard questions you might have, and do some legwork to understand the company as best as you can. If you know a company well enough, you’ll know how well it will potentially grow down the line. This might take a little bit more time but you want to invest in a company with the best chances of future growth and success.
A company must have a strong balance sheet – a good cash position and low, manageable debt levels. You don’t want to invest in a company that might grow quickly over the next few years only to find out that they’re in financial trouble later because they used high levels of debt to aggressively fund its growth. If the company can’t manage its debt, they have to slow or stop its expansion entirely and focus on paying down its loans. In the worst-case scenarios, a company go bankrupt if they can’t repay its debt obligations. So always make sure that the value-growth stock you invest in is not overleveraged.
Warren Buffet lists return on equity (ROE) as one the of the most important criteria for evaluating companies in his annual letters. ROE measures how much profit is generated with the money shareholders have invested in a company. A high ROE means that management is able to allocate capital efficiently to generate returns for shareholders. If you’re investing in a company that retains most of its profits for growth, it should be able to show it can use its equity to generate high returns for shareholders. If not and ROE is poor, there’s no point with the company keeping the money, it might as well pay out the majority of their earnings since they’re unable to generate returns for shareholders. Look for low-debt companies that geneate an ROE of 15% or higher over the past 3-5 years.
For dividend stocks, income investors generally look for stable free cash flow because they want a company to pay out the free cash flow as dividends. For value-growth stocks, free cash flow is usually low or negative because growth companies reinvest much of their cash into capital expenditure (capex) to grow their business. So instead free cash flow, a better way to gauge growth companies is to use operating cash flow. Look for consistently rising operating cash flow. Declining operating cash flow means a company is not generating enough new cash flow from its capex.