My Top Growth Stock for 2020

Welcome to the seventh year of my New Year's prognostications! Now that we're officially into 2020, it's time again for me to reveal my favorite growth stock (just one this time) that I expect to outperform the market.

But before we look ahead, let's look back. 2019 was an excellent year for growth investors, with the S&P 500 up more than 30% (including dividends) and the tech-heavy Nasdaq up nearly 34%. Despite continued trade tensions with China and fears over rising stock valuations, the strength of developing trends such as cloud computing and gene editing was more than enough to restore confidence in growth-style investing. Corporate earnings were healthy, and efficiency improvements helped boost earnings per share higher.

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As you'd expect in growth-style investing, there are some really big winners among my previous picks -- and also some really big losers.

Let's start with the good news. Ubiquiti's (UI 1.12%) disruptive sales approach to offering best-in-class wireless connectivity products has proven extremely profitable, and the stock is up 546% since early 2015. MercadoLibre (MELI 2.11%) has become the one-stop-shop for e-commerce in Latin America, running an online marketplace that also offers shipping and digital payments, and its stock has risen 444% since 2014. Veeva Systems' (VEEV 1.07%) cloud-based solution is improving the sales and research efficiency of drugmakers, and it's up a healthy 433% since 2015. A $1,000 investment into each of those three companies when I recommended them (for a $3,000 total upfront investment) would today be worth more than $17,000.

But it hasn't all been rainbows and butterflies. Stratasys (SSYS -2.03%) vastly overestimated the demand for consumer 3D printing, and its stock has fallen 76% since 2015. And the trade war between the U.S. and China has led to inventory buildups for iRobot (IRBT -1.21%); its shares are down 37% since early 2018.

Still, the consolidated performance of the picks makes a strong case for growth-style investing. Taken together, the average recommendation has provided an absolute return of 112%. On a year-by-year basis, 2014's picks have provided an average absolute return of 165%, 2015's have returned 301%, 2016's have returned 99%, 2017's have returned 48%, 2018's have returned 11%, and 2019's have returned 51%. That's a lot of outperformance!

DATA SOURCES: YAHOO! FINANCE AND S&P DOW JONES INDICES. STARTING PRICES ARE AS OF THE ORIGINAL PUBLISHING DATES: 12/30/13, 1/1/15, 1/5/16, 1/5/17, 1/2/18, and 1/5/19. STARTING PRICES AND TOTAL RETURNS OF MERCADOLIBRE, UBIQUITI, AND THE S&P500 HAVE ALL BEEN ADJUSTED TO ACCOUNT FOR DIVIDENDS. ZILLOW SPLIT INTO TWO CLASSES DURING 2015; WE ARE TRACKING "ZG." SOLARCITY WAS ACQUIRED BY TESLA MOTORS IN NOVEMBER 2016 IN AN ALL-STOCK DEAL; THE RECENT PRICE REFLECTS THE EQUIVALENT OF 0.11 SHARES OF TSLA AT $418.33. PRICES AND RETURNS ARE AS OF 12/31/19. RETURNS FIGURES HAVE BEEN ROUNDED.

Within this growth-investing strategy is a key element that's worth emphasizing. The outperformance of the winners more than makes up for the underperformance of the losers.

This is a dynamic we've become comfortable with. We know that, historically, only about 40% of the individual recommendations from our Motley Fool Rule Breakers service outperform the S&P. But when taken collectively, the portfolio of Rule Breakers picks from the past 15 years has an average absolute return of 174% -- more than double the 83% return of the market over the same period (figures are as of Jan. 2).

That formula for wealth creation is only possible if you allow your winners to run (i.e., you don't sell them), giving them time to compound their returns and overwhelm the losses from the laggards. But it also requires investors to identify the right companies at the right times, and to have a lot of patience.

The process

To help identify those potential big winners, I always look for these three qualities in growth companies:

1. Operational performance. When you invest, you're buying a stake in a business, so you want to find businesses that are performing very well. Develop a list of meaningful operational metrics that are relevant to the particular industry, and then look for companies that are killing it where it really counts. That means putting less emphasis on the current P/E ratio, and more on metrics that reflect business performance.

2. Smart and visionary management. Growth companies are still growing. That makes them much more sensitive to managerial decisions -- whether good or bad. Look for leaders who are committed to the long-term success of their companies. I like CEOs who are either co-founders or who have significant ownership stakes in their businesses. Preferably both.

3. Huge market potential. Small companies don't always do so well in price wars. Seek out businesses operating in industries large enough to support new players. I look for the company's total annual revenue to be a very small slice of the overall industry.

This year's top growth stock

With that said, it's time to fire up the crystal ball once again. Rather than spreading my conviction across three picks, I'm going all-in on just one stock this time around: Yext (YEXT 1.79%) is my top recommendation for 2020.

Yext is on a mission to improve internet search. It provides a digital platform where businesses can consolidate their public-facing information, then have it distributed to search engines and aggregators like Google or Amazon's Alexa. Think of Yext as a piece of the internet's brain tasked with making its responses to your queries more accurate and relevant.

This initially appealed to consumer-facing companies such as Wendy's and Subway, which wanted to ensure that people looking for store hours and locations found the most up-to-date information. It caught on further with hospital chains, which also wanted to make it clear which insurers they worked with.

But there's a revolution underway in internet search: AI-powered digital assistants are now beginning to facilitate transactions. Today, you might be asking Alexa to tell you about the weather. But tomorrow, you'll be able to have her book you an Uber ride to the nearest doctor who accepts your insurance.

Yext plays a pivotal role in connecting the dots between APIs, helping those soft-spoken digital assistants to pull information that's accurate and then respond accordingly. Its recently released Yext Answers will also soon redefine the custom search of companies' own websites; Campbell's Soup and T-Mobile have signed on as early adopters.

Yext is spending heavily on R&D and on a direct-sales force to meet face-to-face with customers, a strategy that has resulted in hefty operating expenses and stock-based compensation costs. Those outlays have many investors balking -- but a long-term plan is clearly in place. Those upfront R&D and sales costs should translate into years of recurring subscription revenues down the road. Its 34% small-business revenue growth and 67% international growth are great signs that its approach is catching on, while its 107% net retention rate indicates that customers are indeed spending more over time. 

Yext's co-founder and CEO is Howard Lerman, who brought with him a track record of success from several previous ventures. He's joined on the leadership team by five former executives of salesforce.com, including its former CFO Steve Cakebread, who oversaw the company as it grew its annual sales from $20 million to $1.2 billion. Yext's Chairman is Michael Walrath, a digital media legend who worked at DoubleClick in the late 1990s, and later sold Right Media to Yahoo!.

This is an experienced management team that knows a boatload about developing long-term customer relationships. Lerman owns around 5% of Yext's outstanding shares.

In today's world, no company can afford to compromise on its consumer-facing digital brand. Yext is enabling web-based transactions and is building more-responsive websites, capitalizing on long-term trends that could provide significant future growth.

The Foolish bottom line

I believe Yext's visionary management team and solid execution offer a unique opportunity to patient investors. We'll see what the future holds for its shareholders, in 2020 and beyond.