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 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 XM Satellite Radio's 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.

Over the past 10 years, Ann Taylor Stores (NYSE: ANN) has grown its revenue at an 11.4% annual clip. Chico's (NYSE: CHS), on the other hand, grew its revenue at an impressive 38.4% pace. As you might expect, investors did much better in Chico's. A $1,000 investment in Chico's grew to $34,738, while an equivalent investment in Ann Taylor would be worth only $5,214. 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.

You should pay as much attention to a business's competitive position as to its rate of growth. CME Group (NYSE: CME), which runs the Chicago Mercantile Exchange, one of the main U.S. futures and options exchanges, has network effects that kept competitors away. Both buyers and sellers flock to the busiest exchange, because the more traders at an exchange, the better liquidity, the tighter the spreads, and the lower the transaction costs. This competitive advantage has helped the Chicago Mercantile Exchange grow for more than 100 years.

Similarly, First Data (NYSE: FDC) has enjoyed incredible success by constantly improving its sustainable competitive advantages in payment processing worldwide. Its point-of-sale systems handle a huge number of credit card transactions every day. And its STAR network handles one-quarter of all ATM transactions in the United States. Shareholders have ridden its competitive advantage to handsome profits. In the first decade after it was spun off from American Express  (NYSE: AXP), First Data shares appreciated 30% per year. That's great sustainable growth.

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.

Take Business Objects (Nasdaq: BOBJ), for example. Its software products are still recognized as leading the business intelligence market, and the company has continued to grow its revenue at a good rate. Yet the stock is being acquired for a price well off its 2000 highs, mainly because it was so overpriced seven years ago that no amount of performance would have kept propelling it up.

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.

Fool contributor Richard Gibbons was hoping for sustainable growth, but he stopped at 6'2". Richard does not own shares of any company mentioned in this article. The Fool has a disclosure policy.