The other day I was reading a classic 2005 article by Motley Fool co-founder David Gardner detailing six signs he looks for in high-growth, high-return companies. I couldn't help noticing that one of my favorite companies, Ambarella (NASDAQ:AMBA), currently exhibits all of these characteristics. If you haven't already, read David's 2005 article first. Then we'll take each of these signs and compare them with Ambarella, which is indeed a recommendation of The Motley Fool's Rule Breakers newsletter, where David is "chief rule breaker."
Sign No. 1: Top dog and first-mover in an important, emerging industry
Ambarella designs video processing chips used in high-definition cameras. Most notably, its chips are used in wearable action cameras such as the GoPro line, but the chips are also designed into security cameras, dashboard cameras, and now cameras for drones.
Cameras and camcorders have been around for a long time. But small, portable cameras capable of high-definition video and still images are quickly growing and becoming an important industry.
Ambarella's chips are currently the highest quality on the market, staying ahead of the competition in resolution and capabilities. They also consumer very little power, making them ideal for use in small cameras that don't need extra-bulky batteries. That's why they're the choice for the GoPro series, which are all relatively high-end action cameras, as well as drone cameras that need a light payload.
Ambarella also serves the IP security-camera industry, which is set to explode as high-definition digital systems replace old analog closed-circuit equipment. Some analysts are estimating the IP security market to be worth $57 billion by 2020, a 37% annual compound growth rate.
Sign No. 2: Sustainable advantage gained through business momentum, patent protection, visionary leadership, or inept competitors
Ambarella produces the most complex part of a video camera, the video processor. It takes the raw video and converts it into a format that can be stored and distributed efficiently. While the actual product Ambarella designs is a physical chip, there is still a large amount of engineering and proprietary algorithms that go into its design. This is what determines how efficient the chip is in converting the video, how much power it uses, and how well it operates in various conditions such as low light.
Ambarella's core engineering team has worked together for over 15 years. Not only have they built up a lot of experience, but they also designed various video protocols that are standard today. Because intellectual property is the company's largest asset, it's encouraging to see at least 70% of Ambarella's 500-odd employees work in research and development. Competitors, such as large electronic makers like Sony, could choose to design and build their own chips, but it would take some time.
This is still perhaps the weakest point for Ambarella. Anyone who follows consumer electronics and chips knows that even if you're the best, margins or market share can be eroded by a competitor that's "good enough" but much cheaper.
But this is the nature of a healthy, competitive marketplace and is not a reason to avoid growth stocks. The competitive landscape is worth keeping a close eye on, but so far sales have continued to grow, and margins are holding up well for Ambarella.
Sign No. 3: Strong past price appreciation
This is by far the easiest box to check for AMBA. Year to date, the stock is up 119%, and over the past year it's up 270%. Not only is there strong price appreciation, but it's been backed up by equally impressive sales and income growth. Year-over-year quarterly revenue has been increasing by double digits over the past four quarters. Furthermore, this revenue growth has been accelerating -- the mark of a growth company hitting its stride. Net income is showing similar strength, recently reaching triple-digit growth.
The stock price did suffer a 25% drop on a negative research report (more on that in a moment), but this was due to valuation concerns, not a fundamental problem. Regular pullbacks should be expected with red-hot growth stocks and can be healthy as the stock takes a breather before advancing higher.
Sign No. 4: Good management and smart backing
This one is a bit harder to gauge, but we can easily see that Ambarella's founder, Fermi Wang, is still CEO and has a long history of developing video-compression technology as well as successfully starting other companies before selling them.
The current chief technology officer and executive VP are also electronic engineers by trade. In addition, the CTO and CEO previously co-founded a company together, and a number of Ambarella's other executive managers were also part of that venture.
Sign No. 5: Strong consumer appeal
Ambarella isn't a household name, as its product isn't sold directly to consumers. However, the GoPro camera line is well-known and camera-equipped drones are becoming more popular. In his 2005 article, David talked about looking for companies that provide products or services that improve the quality of people's lives. Consumers are increasingly aware of the need for and use of security cameras, specifically body cameras for law enforcement, which Ambarella contributes to.
Sign No. 6: You must find documented proof that it is overvalued according to the financial media
This is another easy one to check off, as notable short-seller Citron Research in June issued a report claiming that Ambarella was incredibly overvalued. The report sent the stock tumbling 25% in the following two days, but it's already showing signs of recovery.
To be fair, Citron and other commentators on Ambarella's rich valuation have a point. The stock currently trades near a 55 P/E ratio, although the forward P/E is sitting at 30. But every growth stock looks expensive on a P/E basis, as investors are willing to pay a premium for such high growth. To quote David from his article, "Yes, Virginia, you can pay 100 times earnings and still about triple your money in four years."
In conclusion, Ambarella comes out strong after going over the checklist, fulfilling the six characteristics of a classic growth stock. With its blistering growth and sometimes volatile price action, it certainly isn't for the faint of heart. But any company that fulfills these six criteria deserves serious consideration for your portfolio.
Chris Kuiper has no position in any stocks mentioned. The Motley Fool recommends Ambarella, Apple, and GoPro. The Motley Fool owns shares of Ambarella, Apple, and GoPro. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.