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 what happened to Sun Microsystems (Nasdaq: JAVA ) in late 2000.
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.
Since 2003, Yum! Brands (NYSE: YUM ) has grown operating cash flow at 8.5% per year. Meanwhile, McDonald's (NYSE: MCD ) has grown at a 13% clip over that same time frame. As you might expect, McDonald's investors did much better. A $1,000 investment in McDonald's would be worth $2,604, while the same investment in Yum! shares would be worth just $1,857 today. It can pay to find the faster-growing stock in the industry.
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 position of the business as you do to the rate of growth. With market share approaching 80%, Google's (Nasdaq: GOOG ) ubiquitous search engine is by far the most popular on the planet, leaving its closest competitors -- Yahoo! (Nasdaq: YHOO ) , Microsoft (Nasdaq: MSFT ) , and AOL -- to duke it out for No. 2.
Google achieved its success with a slightly faster, more relevant search algorithm. Once its engine's popularity gained critical mass, advertisers clamored for access to its AdWords placement and AdSense network. The cash Google generates from these ads allows it to continue outpacing its competitors by improving its algorithm, grabbing new market share, and introducing innovative applications. This competitive advantage has helped Google shares triple since the IPO in 2004.
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 Oracle (Nasdaq: ORCL ) , for example. The company has more than quadrupled its earnings since 1999, yet shareholders have lost most of their investment since then, mainly because it was so overpriced at the time that no amount of performance could have kept propelling it up.
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.
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 any companies mentioned. Google is a Motley Fool Rule Breakers recommendation. Microsoft is an Inside Value choice. The Fool has a disclosure policy.