The Growth Stocks You Should Buy

Probably the biggest misunderstanding about value investors is how we approach growth.

Consider these two groups of growth stocks. Which group would be more attractive to a value investor?

Group 1 Stock

Projected Growth Rate

Price-to-Earnings

Apple (Nasdaq: AAPL  )

23%

36

Google (Nasdaq: GOOG  )

28%

38

NYSE Euronext (NYSE: NYX  )

21%

24

Average

24%

33

Group 2 Stock

Projected Growth Rate

Price-to-Earnings

AU Optronics (NYSE: AUO  )

20%

8

Smith International (NYSE: SII  )

22%

24

Cognizant Technology (Nasdaq: CTSH  )

30%

27

Average

24%

20

Both groups have roughly the same projected growth rates, but the latter group is significantly cheaper as multiple of earnings. So, it might seem obvious that a value investor would prefer the second group of stocks.

Not so fast
But actually, most value investors would probably prefer the first group. One of Warren Buffett's most important lessons is about the quality of the business: It is critical. Buffett would rather buy a great business at a fair price than a fair business at a great price.

Predictable, sustainable growth is both rare and valuable. If you buy a fair business at a great price, you have little choice but to sell when the stock returns to its intrinsic value. After that point, the returns from the business are likely to be mediocre.

Great businesses, on the other hand, have excellent ongoing returns. They are more predictable, can raise prices more easily, and enjoy a competitive advantage. You don't need to rush to sell a great business because it can print money for years or even decades.

What's more, a great business is more likely to be able to overcome roadblocks. Coca-Cola (NYSE: KO  ) was able to survive the "New Coke" fiasco because the underlying business and brand were so strong. Alta Vista, on the other hand, had no chance of recovery after Google came along with a better search engine.

Sustainable growers
In other words, most value investors would prefer the first group of growth stocks, despite the higher earnings multiple, because they are sustainable investments.

Apple is possibly the most innovative company on the planet. Its attractive brand and loyal customers allowed it to survive years of mediocrity. And now, after a few years under the visionary leadership of Steve Jobs, Apple is dominant in the online music business, owns the MP3 player market, is making waves in the mobile phone market, and is seeing increased interest in its core computer business.

Google, too, has an impressively competitive position. It started with search technology that was simply better than everyone else's. Now, Google owns about 60% of the online search market -- almost triple the No. 2 player -- and it's still growing. The company brings in more ad revenue than any other online business. As if that weren't enough, Google is the employer of choice in Silicon Valley, attracting the world's best high-tech minds. It's an extremely difficult business to displace.

NYSE Euronext owns the most prestigious stock exchange in the world. The New York Stock Exchange is huge, and size really matters when it comes to exchanges. The more people who trade on a given exchange, the better the liquidity and the tighter the bid-ask spreads. Traders have a better chance of getting a trade at the price they want on the most liquid exchange. Thus, traders naturally gravitate to the NYSE.

All three of these companies have strong, defensible competitive positions and the potential for superior long-term growth -- and that makes them attractive prospects.

Commoditized businesses
Compare those companies with the ones in the second group. AU Optronics manufactures flat panel displays, a relatively commoditized product. It doesn't have a well-known consumer brand, so it doesn't command market share on that basis. If competition ramps up in flat panels, there's little that AU Optronics can do except reduce its prices to try to maintain market share.

Smith International provides services and equipment to the oil industry, which is a highly competitive,  unpredictable industry. If oil prices fall and exploration declines, then Smith will suffer as oil service providers compete for dwindling exploration opportunities.

Cognizant is an information technology consultant and outsourcer, a business particularly subject to the vagaries of the economy. When the economy slows, axing consultants can be an easy way for businesses to reduce their expenses. What's more, there are few barriers against competition, since it isn't difficult to start a consulting company. Even worse, it's a hard business to grow because productivity in consulting companies is directly related to the number of employees. If you want to double your sales, you have to double your workforce. It's not a great business model.

The Foolish bottom line
The companies in the first group are significantly stronger than those in the latter group. They have more defensible positions and are therefore more predictable. They are much more likely to be able to sustain their growth. Thus, despite the higher prices, the value investor will be more inclined to buy those stocks.

That said, none of the companies in either group are Inside Value newsletter recommendations. While the first group is attractive, our team of value investors sees better opportunities right now.

This year's volatility has left many companies that offer sustainable growth trading at extremely compelling prices -- some for less than half of what they're worth. These are the stocks that we're targeting. If you want to see our favorites, we offer a free trial.

Fool contributor Richard Gibbons will be bitter when his writing job is outsourced to Cognizant's Indian offices. He does not have a position in any of the stocks discussed in this article. Coke is an Inside Value choice. Apple is a Stock Advisor pick. NYSE Euronext is a Rule Breakers recommendation. The Fool's disclosure policy hates geese.


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