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

Amazon.com (Nasdaq: AMZN  )

24%

66

Iron Mountain (NYSE: IRM  )

22%

35

Mindray Medical (NYSE: MR  )

39%

44

Average

28%

48

Group 2 Stock

Projected Growth Rate

Price-to-Earnings

Cognizant Technology Solutions

28%

22

Himax Technologies (Nasdaq: HIMX  )

20%

6

Shanda Interactive Entertainment (Nasdaq: SNDA  )

20%

10

Average

23%

12

Both groups have above-average projected growth rates, but the latter group is significantly cheaper based on earnings multiples. 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. Nike (NYSE: NKE  ) was able to survive the "sweatshop" 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.

Amazon.com is the dominant name in online retail. Its attractive brand and loyal customers allowed it to survive the dot-com bust. And today, the company continues to innovate, with its popular new wireless kindle reading device and upcoming streaming on-demand video service.

Iron Mountain, too, has an impressively competitive position. The company is the information protection, storage, and destruction source for more than 100,000 corporate clients. Data security and records management is a critical corporate function, and these guys do it better than anyone -- this is an extremely difficult business to displace.

Mindray Medical may not be as well-known, but this Chinese medical device manufacturer is able to offer high-quality products at a fraction of the costs of its peers. Thanks to a cheap labor source and a world-class R&D team, Mindray can afford to undercut its competition and still turn a tidy profit.

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. Himax makes semiconductors, 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, there's little that the company can do except reduce its prices to try to maintain market share.

Shanda operates online games in China. But it may be "game over" for the company if the Chinese government allows its citizens to purchase console gaming systems like the Xbox 360 or Sony's (NYSE: SNE  ) PlayStation 3.

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, click here for a 30-day free trial.

This article was first published May 20, 2008. It has been updated.

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. Amazon.com is a Stock Advisor pick. Google, Mindray Medical, and Shanda are Rule Breakers recommendations. The Fool's disclosure policy hates geese.


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