The Best Growth Stocks

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As an investor, you should always be on the lookout for growth. Share prices tend to follow a company's value, so investors should seek companies that are rising in value. 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 can't just look for 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 what's been happening to trailblazing GPS device maker Garmin (Nasdaq: GRMN) this year.

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 make a big difference to investors.

Over the past five years, ConocoPhillips has grown its revenue at 28% per year. Meanwhile, PetroChina has grown its revenue at an incredible 31% annual clip over that same time. As you might expect, investors in PetroChina did much better. A $1,000 investment in PetroChina would be worth $5,168 today, while the same investment in ConocoPhillips shares would be worth "just" $3,805. 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 involves focusing on the growth rate, but ignoring the sustainability of that 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 advantage of the business as you do to the rate of growth. eBay (Nasdaq: EBAY) runs the undisputed largest online auction site in the U.S. Its network effects -- buyers choose eBay because that's where the sellers are, and vice versa -- result in a competitive position that Yahoo! (Nasdaq: YHOO) failed to surmount in this country, although it managed to beat eBay to the punch in Taiwan and Japan.

eBay has rewarded early shareholders with a 1,300% return since its 1998 public debut. The company continues to battle with Gmarket (Nasdaq: GMKT) in South Korea; in Latin America, it took a substantial stake in MercadoLibre (Nasdaq: MELI), which is dominating that market. The winner-take-all economics of online auctioning could mean similar returns for the victor in those regions.

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.

The tremendous potential of satellite radio providers Sirius (Nasdaq: SIRI) and XM Satellite Radio (Nasdaq: XMSR) was obvious to everyone by the turn of the century. But despite booming sales, their stocks have hardly been rewarding to investors who bought during the tech bubble. Each is down more than 80% since their 2000 highs.

So before buying a growth stock, make sure it's undervalued, or at least fairly priced. A discounted cash flow (DCF) calculation is a great way to work out the fair value of a growth company. If you don't know how, our 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 increasing your risk while 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. It pays to constantly search for such businesses, the kind that 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.