Investors looking to build a growth investing portfolio can either use some form of stock recommendation service or for the more involved investor they can find their own good quality growth stocks using a stock screening tool.
Regardless of whether the investor uses a stock screening tool, it’s beneficial if the investor understands how the stock selection process works.
For investors’ selecting their own stocks, the easiest way to get started is to use a web based stock screener. There are dozens to choose from (both free and paid). Some of the free web based stock screeners are finance.yahoo.com and nasdaq.com
For this article I used morningstar.com which has a free membership based stock screener. This means the investor must sign up for a membership but it is free. The advantage of using Morningstar is that they provide five years of revenue and earnings history whereas Yahoo only provides three years.
How much historical revenue and earnings data to use is a personal choice but generally it’s better to use more data than less as it gives a more complete picture of the company’s history.
To get started the investor needs to first determine what type of stocks to search for – which for this article is growth stocks. Thus we are looking for stocks with good historical revenue growth and earnings growth with the potential to produce good revenue and earnings growth into the future.
Using the Stock Screener
To run a screen is quite straight forward and all the investor needs to do is select some criteria and click the Search button.
Since investors love the smaller growth companies (due to their high return potential) I will run the Morningstar screen for Mid-cap growth stocks and again for Small-cap growth stocks (using Growth grade A and B).
The screen-lists can contain a hundred or more stocks. Additional criteria can be selected to reduce the size of the lists. For example the investor can select a 3-year revenue growth of say 10% minimum.
The screen-lists typically contain some good growth stocks but most of the stocks in the list are usually poor growth candidates and are not worth buying.
Check the Revenue and Earnings History
The investor now needs to go though each screen-list one stock at a time to produce a short-list of the better growth candidates. The investor needs to visually check each stock’s five year revenue and earnings history and pick the stocks for a short-list that generally show an increasing revenue and earnings growth trend.
An example of a stock showing the desired revenue and earnings trend is shown below in Table 1. for ACET.
Table 1. ACET – Strong Earnings growth trend
Table 1. above shows a general increase year after year for both the revenue and earnings. This stock shows a strong growth trend.
An example of the earnings profile that is generally undesirable for a growth stock is shown below in Table 2. for BLKB.
Table 2. BLKB – Poor Earnings growth trend
While Table 2. above shows a stock with an increasing revenue trend, the stock’s earnings are actually showing a downwards trend (the highest earnings were in 2011).
The investor can now use a spreadsheet table to build a short-list of the best revenue and earnings growth trending stocks and ignore the marginal and poor earnings growth stocks.
The next step is to calculate the revenue and earnings growth rates using the spreadsheet.
Calculate the Historical Growth Rates
The historical growth rates are typically not shown with web based screens or if they are given they are not annualized rates.
Calculating the annualized growth rates for each stock is straight forward. The investor only needs to obtain two years of data – the latest historical revenue and the revenue from five years ago. Similarly for the historical earnings the investor only needs the latest earnings and the earnings from five years ago.
Referring to Table 1. above, the latest revenue and earnings are from 2015 (for companies with a fiscal year ending December) and the five year ago revenue and earnings are from 2011.
The five year historical growth rates can now be calculated using the following formula:
Annual Revenue growth rate = ((Revenue1/Revenue2) ^ (1/4yrs) – 1) x 100%
Annual Earnings growth rate = ((Earnings1/Earnings2) ^ (1/4yrs) – 1) x 100%
Where:
- Revenue1 means the latest historical revenue.
- Revenue2 means the revenue from five years ago.
- Earnings1 means the latest historical earnings.
- Earnings2 means the earnings from five years ago.
- 4yrs – While there’s five years of data there are only four years of increases.
Forecast Revenue and Earnings growth rates
Investors looking for free forecast data can use finance.yahoo.com which gives broker consensus estimates for both the revenue and earnings over the next two fiscal years.
The investor can now calculate the 2016 and 2017 forecast revenue and earnings growth rates using the following formulas:
2016 Revenue growth rate = (Revenue2016 – Revenue2015) / Revenue2015 x 100%
2017 Revenue growth rate = (Revenue2017 – Revenue2016) / Revenue2016 x 100%
2016 Earnings growth rate = (Earnings2016 – Earnings2015) / Earnings2015 x 100%
2017 Earnings growth rate = (Earnings2017 – Earnings2016) / Earnings2016 x 100%
Where:
- Revenue2015 means the latest historical revenue (which is 2015 for December reporting).
- Revenue2016 means the forecast revenue for 2016.
- Revenue2017 means the forecast revenue for 2017.
- Earnings2015 means the latest historical earnings (which is 2015 for December reporting).
- Earnings2016 means the forecast earnings for 2016.
- Earnings2017 means the forecast earnings for 2017.
The forecast growth rates along with the historical grow rates can be entered into the spreadsheet table. This table might contain 20 or more stocks. Now would be a good time to check what sectors and industries the stocks belong too.
Check the Sectors and Industries
Modern portfolio theory suggests that investors select one stock from each of the ten sectors for a diversified ten stock portfolio.
In practice however it’s common to find lots of good growth stocks in some sectors and none worth buying from the other sectors.
To control risk it is generally better to buy good quality stock selections from say five different sectors rather than including marginal stock selections from the other sectors just to make the portfolio consist of ten sectors. Diversity can still be obtained by including stocks from ten different industries – even if some of these industries come from the same sector.
The Stock Price
In the American stock market there’s a strong correlation with low priced stocks (generally under $10) and the financial strength of the company. Basically the low priced stocks are often under financial distress while the higher priced stocks (especially above $20) tend to be the more financially sound companies. Hence stocks under $10 (and especially under $5) tend to be much higher risk companies than companies with stock prices above $10 (and especially above $20).
Most of the financially sound companies tend to have stock prices above $20. That’s the nature of the American stock market, so a simple tactic to reduce risk when dealing with the smaller companies is to pick stocks that are priced above $20.
The Final Ten Stocks
The investor can now pick their ten stocks. The stocks picked are a personal choice and different investors will end up picking different stocks.
The final ten stocks I picked are shown below in Tables 3. and 4. (The data is based on Feb 22, 2016 and the industries are based on the ICB classification).
Table 3. Growth Stocks – Revenue and Earnings Growth
Most of my stock picks have historical revenue growth rates and earnings growth rates well above 10%. While ACETs and THOs historical revenue growth rates are below 10% they were included because they have strong forecast revenue growth and they both displayed strong earnings growth.
Table 4. Growth Stocks – Market cap and Industry
As the investor can see from the above stock picks, I generally picked small and mid-cap growth companies with a stock price above $20. The exception was with SPNS which I included because the company displayed solid and consistent historical growth together with strong forecast growth rates. Also, while the stock price was below $20 it was still above $10.
I also used the consensus broker recommendations and excluded stocks that did not have a Buy or Strong Buy recommendation.
Three of my stock picks came from the Consumer Services sector and another two from the Consumer Goods sector but each stock came from a different industry that are not related to each other.
The strong play on the Consumer sectors was due in part based on my speculating that the current market indices will rally and boost consumer confidence from the current minor market correction.
This style of investing ignores the stock price valuation – which assumes that the high revenue and high earnings growth will keep the stock price rising. This tends to be true while the market rises and the stocks typically outperform the market indices. While individual stocks can underperform and even decline in price, a balanced portfolio of quality growth stocks will typically outperform the market.