3 Crucial Steps to Pinpoint Growth-Share Winners

LONDON -- I wonder how many of you are familiar with the "amoeba theory of growth investing." Anyone?

I'll hazard a guess and say not many because it is an idea I came up with while playing around with my calculator. So without further ado, here it is.

Q: If an amoeba in a jar doubled every second, and it took precisely one minute for the amoebas to fill the jar, how long would it take for the jar to be exactly half full?

(Hint 1: Forget about the size of the jar and the size of the amoeba.)

(Hint 2: The answer is not 30 seconds.)

The correct answer is of course 59 seconds, because one second after that -- at precisely one minute -- the amoebas will have doubled and the jar would become full.

Still with me? Excellent! 

But what does this have to do with growth investing? As it turns out, quite a bit. Allow me to explain.

The good old growth days
Growth investing is all about buying companies that can expand much faster than the wider economy.

If you are as old as me, you'll remember that growth shares last became very popular during the '90s. In particular, companies associated with technology, media, and telecoms (then known collectively as TMTs) were all the rage back then. Growth investors were making money hand over fist -- often effortlessly.

Unfortunately, many growth investors hit big trouble after the tech boom peaked during early 2000. You see, the bursting of the dot-com bubble was a bit like my jar of amoebas after 59 seconds. 

All those TMTs had seen longtime rapid earnings growth, as my three examples in this table show...

But suddenly, the amazing profit growth within the TMT sectors came to a stop and some racy P/Es were left extremely exposed. For TMT investors, at least, the amoeba jar had become completely full!

In fact, Logica's earnings actually collapsed by two-thirds between 2000 and 2003 as tech boom turned to bust. In addition, Vodafone saw its profits slump 20% during 2001 while WPP's earnings dropped 18% between 2000 and 2002.

My next table summarizes the share-price fallout at the tech-crash low during 2002-03:

The combination of falling earnings and a de-rated P/E spelled disastrous returns for growth investors. 

So how can you profit from growth companies?
I must admit, I took my knocks during the dot-com bust. Indeed, I was one of the many that saw their GEC holdings turn into Marconi... which then turned into nothing!

However, my experience in the tech crash -- as well as observing the varying fortunes of growth companies before and since -- have helped me devise these three crucial steps for sorting the growth-share wheat from the also-ran chaff.

1. A good track record... in good times and bad
Companies with records of rising profits are obvious contenders for a growth-share portfolio. But it's important to consider the business environment when the great track record was established. You see, the record may have been buoyed by favorable events (e.g., the advent of the Internet in the '90s), and the business might actually crumble in a downturn.

Thankfully, we don't have this problem right now -- as any firm that's recorded consistent growth in the last few recessionary years must surely possess special growth qualities! But as and when the economy improves, the chances of being tricked by a growth-share imposter will increase.

2. Know your (market's) limits
Many of the very best growth shares operate in sectors with tailwinds behind them, which should allow profits to extend further as the sector expands. Trouble is, tailwinds so often become headwinds -- and you end up with a full jar of amoebas!

I've seen many mini-growth sectors come and go in my time, but an area particularly prone to growth-share disappointment is the consumer rollout." Shops, gyms, restaurants, or similar -- all can be rolled out across the country to generate super earnings growth. But with Britain being a small island, there are only so many towns and cities to cover before saturation hits... and the amoebas fill the jar.

3. Pay a fair price for growth
Paying the right price for growth can be very difficult, as I've seen excited investors extrapolate rapid earnings growth well into the future to justify extreme valuations. Sometimes no price can be too high!

But as late-'90s TMT investors know, pay too rich a P/E and your losses will be heavy if your projections are too optimistic. So you have to weigh up the rate of further earnings growth, the risk of things going wrong, and what the P/E is already expecting. In fact, I've found backing mid-range growers on mid-range multiples can frequently offer more reliability than going for full-on growers on tip-top P/Es.

One idea to take away 
Now I can't leave you today without a growth idea of my own. I've not looked at Serco (LSE: SRP) too closely, but at first glance the FTSE 100 share appears to fit my basic checklist.

Certainly the outsourcer has a demonstrable track record. Old annual reports show sales and profits growing every year since the firm's late-'80s flotation, which tells me the business is a reliable performer in the good times and the bad. Recent progress has not been too shabby, either, with earnings doubling in the last five years.

I also feel the outsourcing industry enjoys a tailwind. There are plenty of government cost savings to be made and Serco itself reckons the sector could keep expanding at 5%-7% per annum (link opens PDF file). What's more, an 18 billion pound order book looks attractive when sales are currently 5 billion pounds.

And in terms of valuation, a 553 pence share price and forecast P/E of 13 does not look too outlandish given the firm's time-tested history and recent progress. 

David Kuo writes for Motley Fool Share Advisor, our premium share-tipping service that provides two top investments each month. Try it out today with our 30-day free trial.