After years of lagging stodgier market behemoths during the early 2000s, growth stocks had a dramatic reversal of fortune. Yet while growth and value cycle in and out of favor, there's always a place for stocks expected to drive the economy's expansion.
Room to run
The market expects these ambitious highfliers to grow at a faster clip than the broader market -- thus, they frequently sport the high price multiples to match. But just because these stocks may look expensive doesn't mean that there aren't good buys to be found. Often, growth stocks stay expensive -- while building earnings and seeing stock prices climb ever upward.
In addition, you can often find growth stocks trading at a significant markdown to their prospects. When markets are choppy, investors tend to flock to more defensive strategies like value investing, leaving growth stocks artificially out of demand.
A word to the Foolish
Growth stocks are stacked with higher expectations than the market at large. If a company that's boosted by Wall Street's rosy projections fails to, say, roll out a hotly anticipated product, it can face bitter repercussions. When the market slips, its highest fliers have the farthest to fall.
Our advice? Don't sell your portfolio short. Instead, carefully calibrate your holdings so that, in addition to growth, they also provide judicious exposure to value fare -- a tack that offers you the potential for market-besting gains, delivered via a lineup designed to help dampen volatility. Let's take a closer look at how to inject some growth into your investments.
1. Earnings growth forecasts: For growth investing, this gauge should be among your first research stops, since it estimates the potential profit expansion of a business. Head to Yahoo! Finance's Analyst Estimates area, and pay special attention to the five-year numbers toward the bottom of the page. What constitutes robust earnings growth will vary by industry, but we recommend using 15% as a minimum cutoff for growth stocks.
Yes, that's an arbitrary number -- arbitrarily high. If you're going to pay a premium and buckle your seatbelt for an erratic market, ensure that you're getting the biggest bang for your growth bucks. Remember, Wall Street analysts have a habit of painting cheery scenarios: That 15% figure could receive a significant markdown if a business posts a disappointing quarter.
2. Standard deviation: This measurement of volatility is mainly useful for growth fund investors, providing insight into how a fund has performed amid market swings. It assesses how far an investment's performance has swung relative to a mean return. But on its own, this metric isn't especially revealing.
How to proceed? As you inspect a fund's standard deviation, be sure to do so relative to the broader market, and if possible, close rivals as well. Standard deviations can vary widely over time -- for instance, the S&P 500's standard deviation from 2004 to 2007 was roughly 7.4, while it was about 11 when you expand the range to include 2002 to 2007. Figures higher than those indicate that a stock has given investors a bumpier ride relative to the S&P.
3. Forward price-to-earnings ratio: Here's a useful twist on the tried-and-true P/E: When calculating, substitute a company's estimated future earnings for its most recent four quarters. Voila! You've arrived at its forward P/E -- a yardstick for measuring whether a stock looks pricey relative to expectations. Those bold ambitions frequently have a way of fizzling out, so you'll want to use a company's forward P/E in tandem with its current P/E, which relies on reported earnings. (Conveniently enough, both are available via Yahoo! Finance's Key Statistics page.)
But still, with growth stocks in particular, the focus is on the future. Once you've discounted for the inherent optimism of analysts, a company's forward P/E can help you identify bargains among the market's most punchy prospects.
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