How to pick High Growth Stocks for your Investment Portfolio – Lessons from Pete Tan, Investment Coach, Value Investing College
If you’ve been investing for a while, you would have heard of the term growth stocks. Growth stocks are stocks that are expected to grow in capital gains, over a period of time, at a pace that exceeds the overall market.
While investing in growth stocks involves as much fundamental analysis and in-depth study as investing in value stocks, the basis for investing in growth stocks is vastly different from their better known counterparts.
Value investors look for stocks that are trading at a discount to their current valuations, which growth investors look for stocks that are at a discount to their anticipated future valuations. Value investors profit from dividend payouts and capital gains, while growth investors profit largely from capital gains.
The real question you would have is how you can find a high growth stock amidst the plethora of stocks available, and how you can invest in it safely, within your risk tolerance.
ZUU online met with Pete Tan, Investment Coach at Value Investing College to find out just how.
How do you identify a high growth stock?
For me, a high growth stock is not determined by a percentage. I look for certain criteria to see how much more a company can grow in their revenue and market reach.
- Do they have room to grow based on the size of the industry?
A company with a niche business is always good, but if the industry is too small, it limits the company’s growth.
- Do they have a strategy to expand?
There are some businesses who are pretty contented with where they are and have no intention of growing beyond their country or their local market.
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Is there a percentage of growth that would qualify the stock as a high growth stock?
If you really must put a number to it, I would say that any high growth company, they should have a topline growth for at least the last 3-4 quarters, even if their earnings are not growing yet. I look for about 15% to 20% growth in the recent quarters if possible. That gives me a sign that their growth strategy is working and they are executing it well.
If they show topline growth over a number of years, that would be even better, but many growth companies are new, and they may not have the track record to show for it. So I will just focus on the recent quarters.
There are some other criteria I look out for when identifying a high growth stock.
- Is it an asset light business?
At present, high growth companies tend to be asset light businesses. So when I am looking for high growth stocks and I find one company whose business model is asset heavy and another that is asset light, I would prefer the company with an asset light business model.
- Does it have a recurring business model?
If they have a recurring business model, like a subscription model, or something that compels people to go back to them over and over again, that would be a plus as well.
- Does it have a clean balance sheet?
I like to look for companies with a very clean balance sheet, so I know that they are growing organically, and not because they are putting on a lot of debt. I also look at whether there is anything funny in their balance sheet which sheds some light on the company’s management team. For example, are there very high good will numbers? Has the management team pledged a lot of their shares for something? Those are some things I look out for as well.
- Is there a good management team in place?
The thing about most small high growth companies is that, the management is very important. You need a management team that is trustworthy and very good at execution. I will look at whether the management team has been fulfilling what they have talked about in their past earnings calls. If they said they are going to do something by 2019 in their last few earnings calls, come 2019 I will want to see that they have done it. If they haven’t, I will want to know why.
Are growth stocks always small caps?
I would say that is mostly the case, because it really depends on what you mean by high growth: Is 10% high growth or is 20% or more high growth? It’s much harder for big caps and mega caps to grow more than 20% because of their size. Their size is the enemy of their return.
But there are exceptions. Amazon is a mega cap that has grown above 20% in the last 5 years or so. By and large, most growth stocks are medium to small caps, even micro caps.
What are some common mistakes that investors make when investing in growth stocks?
Many people fail to realize that high growth stocks come with a lot of volatility, because these small companies may be very illiquid. Many people are very happy when they buy high growth stocks and see the price going up, but they are not able to stomach the downturn when it happens. I have seen huge volatility in growth investing, one stock I currently own even went down by 60% in a single day.
Another mistake is not having the investment time horizon that matches the business. From my experience, the growth of businesses is seldom linear. It often looks like a hockey stick, where its share price grows exponentially at the tail end of the timeline. So if you’re looking for a high growth stock, it’s unlikely going to perform in the next 6 months or a year. You have to give it a longer time horizon that suits the business model.
Last but not least, since some of these companies are less well known, there is a lot less available research on them, so another mistake they often make is not understanding the business well enough. If you have no idea what the business does and you think that it is a high growth stock and then you just pile on the money, you will be very badly burned.
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What were some of your best and worst investments
I’m invested in this very small company called XPEL ltd, they do protective film for cars. it’s a very niche based business but the market is there, especially in the U.S. where people are crazy about cars and they have a patent for their film.
It was a turnaround story where they changed the management, and the current management is now executing really well. They have been achieving a 15% topline growth for the last 5 quarters, and this is a good example of how they fit my checklist when I look for high growth companies.
- Does it have room to grow? Yes
- Do they have a strategy to grow overseas? Yes
- Is it an asset light company? Yes, they don’t own any machines, they just send the film over to the car companies.
- Is it a niche company? Yes, pretty much. It’s only them and 3M and 3M is not focusing much here because they’ve got bigger fish to fry.
To be honest when I talk about this company to some of my investor friends, they have never heard about it, because it’s just such a small company. it’s quite illiquid, it’s rarely traded in the market, but it has been one of my best performing one this year. I bought it in early March 18 at $2, and now it’s about $6, so it has grown 3 times. More importantly, their orders have been coming in and they have been expanding overseas as well. I am still holding on to it, with no intention to sell it anytime soon.
The worst investment I made was a US listed hardwood retailer, called Lumber Liquidators. When I was doing my research, I thought the demand for their wood would be relatively okay. So I invested into this company in late 2015, thinking that it was cheap, but the price fell even further after that, and till today, it has never recovered.
I realized the problem was that I didn’t understand the business enough, I didn’t understand how they were conducting their business, and how they sourced their wood. As it turned out, they were found to have used wood from unsustainable sources, they faced a lot of sanctions from different companies, and people stopped buying from them.
Any advice for high growth investors?
For anyone who wants to invest in high growth stocks, you need to have a very mature investing mindset to begin with. You need to know this is not going to be a very short term investment, and you need to understand the business sufficiently to gain more confidence.
Most importantly it is to choose a suitable position size for your investments. Understand what is your risk tolerance. If you are a highly risk adverse person, you should allocate not more than 10% of your portfolio in high growth stocks. If you are more comfortable with risk, you can take a 30% downturn or 40%, you can allocate a larger proportion for high growth stocks.
Ask yourself: If your entire high growth portfolio goes to zero, will you be okay with it?
The risk of this happening is much higher when investing in high growth stocks than say investing in a very safe REIT or blue chip company.
Lastly, always go into your investment in stages. If you are confident in a company and you have the intention of putting in $10,000, put in $3,000 first. Then do a bit more research, if you find it better, put in another $3,000. Slowly add to your position, as you understand more about the company and understand it better.
And of course, always diversify. Don’t throw everything into one basket.
Learning about high growth stocks is just one of the things that is taught at Value Investing College. If you’d like to know how to valuate, add high growth stocks to your portfolio and even more, do register for our complimentary Value Growth Workshop! We’ll even share some real life profitable case studies that you can implement in your investment strategy!