5 Signs of Winning Growth Stocks

Like most of you serious investors, I have a library of books covering various aspects of the subject. My favorite remains Peter Lynch's One Up on Wall Street -- it's the book that convinced me I could invest in stocks. Another near the top of my list is Hewitt Heiserman Jr.'s It's Earnings That Count, which helped me form a specific intellectual framework for picking stocks. Now I'm reading Joel Greenblatt's You Can Be A Stock Market Genius. Only 60 pages in, I already find myself ravenous for more, devouring each sentence like a thick, juicy steak.

I love Greenblatt's penchant for skewering common wisdom. You know, the kind of common wisdom that says outsized returns come from taking outsized risks. Were this true, we'd all load up our portfolios with Rule Breakers and be done with it. But investing isn't that easy -- it requires work. You must work to uncover situations where you have an unfair economic advantage. And that, says Greenblatt, is what produces big stock market rewards.

I find this encouraging because I've adopted this very Foolish approach. Today, I'm going to take you under the hood and show you how I do it.

Five things
There are many different ways to perform due diligence. But for potential Rule Breakers, I suggest checking the five things that most spur economic value for bootstrapping young firms. They are:

  1. An important business driver that has gone unnoticed.
  2. A catalyst.
  3. Shareholder-friendly management.
  4. A substantial market that's growing.
  5. A massively popular product or service.

The list isn't perfect, of course. But think about any of your favorite young'uns that became big'uns -- such as Amazon.com (Nasdaq: AMZN  ) or Starbucks (Nasdaq: SBUX  ) -- for a moment. Wasn't Amazon's catalyst e-commerce growth? And did anyone expect that Wi-Fi would drive untold hordes to Starbucks? These were Rule Breaking ideas that drove major economic value for both firms and their shareholders.

Ready to do this for yourself? Good. I've chosen TiVo (Nasdaq: TIVO  ) , the pioneer in digital video recorders (DVRs) and a Motley Fool Stock Advisor recommendation, as our guinea pig. Let's start at the bottom:

5. A massively popular product or service. Fool co-founder and chief Rule Breaker David Gardner recommended TiVo in July 2003. Back then, TiVo had 703,000 subscribers. The next month, in its fiscal 2004 second-quarter earnings release, TiVo reported 90,000 net new subscribers. That easily bested the top end of the prior quarter's guidance. That trend would continue over four of the next seven quarters:

Subscriber additions and guidance
Quarter Total subscriptions Subs added Prior quarter's guidance
Q1 '06 3.32 million 319,000 265,000 to 300,000
Q4 '05 3.01 million 698,000 575,000 to 700,000

Q3 '05

2.30 million 419,000 340,000 to 400,000
Q2 '05 1.88 million 288,000 265,000 to 300,000

Q1 '05

1.59 million 264,000 180,000 to 200,000

Q4 '04

1.33 million 330,000 325,000 to 375,000
Q3 '04 1.00 million 209,000 130,000 to 160,000
Q2 '04 793,000 90,000 65,000 to 80,000


More impressive is that when you look at the past eight quarters as two fiscal years, you see that TiVo has more than doubled its subscriber base each year.

Grade: Pass.

4. A substantial market that's growing. During the recently completed first quarter, the company inked a deal with one-time competitor Comcast (Nasdaq: CMCSA  ) to develop a specialized TiVo service for customers who have its set-top boxes. The service will be available to Comcast's 21 million subscribers beginning next year. That's important, because current partner DirecTV (NYSE: DTV  ) becomes a competitor in 2007.

How important, you ask? Let's do the math: TiVo currently has 2.1 million subscribers through DirecTV, or roughly 15% of its 14 million viewers. Apply a similar percentage to Comcast's base and you end up with 3.2 million. That means even if DirecTV subscribers leave TiVo en masse in two years, Comcast should make up the difference and fuel additional growth.

Grade: Pass.

3. Shareholder-friendly management. TiVo's market cap was $532 million back in July 2003. A recent check of Yahoo! Finance showed the company's current market cap to be $579 million. That's an increase of 8.8%. Sadly, investors saw exactly none of this gain.

That's because TiVo's outstanding share count rose 28% over the same period, from 64 million at the time of David's recommendation to 82 million now. The rampant dilution has countered the impact of real business improvements in moving the stock price. As a result, the shares are down by more than 26% as of this writing.

Grade: Fail.

Two out of three isn't bad, but how does TiVo stack up on the other two counts? To find out, stroll over to Rule Breaker Central by taking a free trial to Motley Fool Rule Breakers. (Current Rule Breakers can find it here.) I'll give you the rest of TiVo's story, and you'll have immediate access to our best stock ideas -- free -- for 30 days. There's never an obligation to subscribe and, as always, the Fool's money-back guarantee stands behind the offer. Click here to learn more.

Fool contributorTim Beyerswishes he had TiVo. He doesn't, nor does he own stock in any of the companies mentioned in this story at the time of publication. To see what's in Tim's portfolio, check out his Fool profile. The Motley Fool isinvestors writing for investorsand has adisclosure policy.


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