The Best Growth Stocks

As an investor, you should always be looking for growth. Share prices tend to follow a company's value, so investors should seek companies that are increasingly more valuable: growth companies. Truly phenomenal stock market returns are made by holding superior companies that grow relentlessly for decades.

But to actually identify the best growth stocks, you have to take a step beyond looking for the companies with the highest projected growth rates. After all, if the market starts to lose faith in the company's prospects, the fall can be horrendous. Just look at Travelzoo's (NASDAQ:TZOO) performance over the past couple of years.

So, we can establish that the best growth stocks offer both huge upside potential and a margin of safety. As such, they should satisfy three conditions:

1. A good growth rate
All else being equal, fast growth is better than slow growth. But, because of compounding, even relatively small changes in the growth rate can mean a big difference to investors.

In the past 10 years, Nordstrom (NYSE:JWN) has grown its revenue a little less than 7% per annum. American Eagle Outfitters (NYSE:AEO), on the other hand, grew its revenue at an impressive 24% annual rate. As you might expect, investors did much better in American Eagle. A $1,000 investment in American Eagle grew to around $25,000, while an equivalent investment in Nordstrom would be worth only $3,500. It can pay to find the fastest-growing stock in the industry.

2. Sustainability
But to achieve truly great results, you need to look beyond growth estimates. One of the biggest blind spots for most growth investors is focusing on the growth rate and ignoring the sustainability of the growth. This myopia was one of the main causes of the tech bubble. People started paying high prices for third-rate companies sporting high growth projections but few competitive advantages. Such investors were hurt badly when the bubble popped and the market for the companies they invested in disappeared.

So you should pay as much attention to the competitive position of the business as you do to the rate of growth. Best Buy's (NYSE:BBY) emphasis on quality and its customer-focused approach has helped the company become the leading electronics retailer, while competitors such as Circuit City (NYSE:CC) and Radio Shack (NYSE:RSH) have tried to copy it and floundered.

3. A good price
One of the biggest mistakes that investors make is paying too much for growth. Occasionally, you can pay a steep price and strong sustained growth will bail you out, but it's common for investors to pay so much that it's almost impossible to make a decent profit even if the growth continues.

Cisco Systems (NASDAQ:CSCO) is the dominant name in networking, but before the tech bubble popped, it was trading at completely unreasonable multiples for such a big business. Consequently, the stock is still 60% off its March 2000 highs.

So before buying a growth stock, make sure it's undervalued, or at least fairly priced. A great way to work out the fair value of a growth company is by using a discounted cash flow (DCF) calculation. If you don't know how, the Motley Fool Inside Value newsletter has an easy-to-use DCF calculator for subscribers. (A free trial is available.) With a few quick clicks, it can tell you what you're paying for and help you avoid paying too much.

The Foolish bottom line
These three ideas are central to a value investment strategy. Value investors aren't just looking for unpopular stocks. If anything, like Warren Buffett, we prefer to purchase strong companies with excellent growth prospects because we recognize that these companies are worth significantly more than weaker companies. At the same time, value investors also know that if you overpay for that growth, you're both increasing risk and reducing potential profits.

The best growth stocks offer sustainable growth at a reasonable price. When you find this sort of stock, the long-term profits can be immense, so it pays to constantly be on the lookout for these businesses. Such companies make up the core of our Inside Value portfolio. If you're looking for investment ideas, you can check it out with a 30-day free guest pass.

This article was originally published on July 14, 2006. It has been updated.