Come on, admit it: Like most of us, you gravitate toward the market's highfliers. You know, the stocks with sex appeal -- and price multiples that make those of the broader market look like the proverbial chicken feed. Google (Nasdaq: GOOG ) , Genentech (NYSE: DNA ) , Bristol-Myers Squibb (NYSE: BMY ) , and Visa (NYSE: V ) , for example, all sport price-to-earnings (P/E) ratios that surpass the broader market's. Monsanto (NYSE: MON ) , Teva Pharmaceutical (Nasdaq: TEVA ) , and Biogen Idec (Nasdaq: BIIB ) also look pricey compared with the market's multiple.
Why are investors willing to pay such premiums? Well, earnings-growth estimates are typically a major factor, but don't discount the aforementioned sex appeal. Not for nothing do highfliers typically garner miles of column inches in the financial press.
How to proceed
If you find yourself besotted with racy growth stocks, your smartest move is to take a cold shower. Remember that the higher they fly, the farther they have to fall when Mr. Market takes a tumble. Just ask folks who invested in the growth-heavy Nasdaq 100 Trust (QQQQ) exchange-traded fund back in early 2000 -- right before the bottom fell out of the market. More than eight years later, those investors are still waiting to see a positive return on their investment.
The good news is that it doesn't have to be that way -- especially not these days. Large-cap stocks of the growth persuasion have been out of favor on a relative basis ever since the market experienced its pre-millennium meltdown. The upshot? Now appears to be an excellent time for investors to go growth shopping. After years of market-lagging performance, that seems to be where the market's bargains lie -- provided you know how to find them.
Three rules of thumb on that front are:
1. Follow the cash flow. Among the big boys, favor growth-oriented companies with a proven ability to generate cash and plow sufficient sums back into expanding their businesses. That's a winning combination -- particularly if they hope to meet those outsized earnings estimates.
2. Compare like with like. Seemingly above-average multiples can be misleading. A P/E of 25 looks high relative to the broader market's P/E (roughly 13), but not so much relative to, say, that of the average biotech company (roughly 59).
3. Don't go whole hog. Be sure to own growth stocks in the context of a well-diversified portfolio that includes more mild-mannered fare. That's a smart way to work toward financial freedom -- and to get your beauty rest at night.
The Foolish bottom line
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This article was originally published on April 5, 2007. It has been updated.
Shannon Zimmerman runs point on the Fool's Ready-Made Millionaire service and doesn't own any of the securities mentioned above. Google is a Motley Fool Rule Breakers recommendation. Biogen Idec is a Stock Advisor selection. The Fool has a strict disclosure policy.