The 100 Fastest Growing Companies. The 100 Best Small-Cap Stocks. Top 100 Large-Cap Growth Stocks. Sound familiar?
In the words of Fool Philip Durell, value guru of the Inside Value newsletter, investors should not cast their nets into the shallow waters when looking for stocks. And shallow waters are where stock lists fish. But this article isn't about bashing stock lists. It's about using them properly. I'm going to be critical. I'll point out some danger zones. And finally, I'll give you my thoughts on how to use these lists Foolishly.
On the surface, BusinessWeek's "Top 100 Hot Growth Companies" would appear to be a great list to draw from. But from May 5 (when BusinessWeek quoted the prices) to August 13, a portfolio of the top 50 of these would have declined 10%, compared with a 1.5% slide for the S&P 500. Sure, growth companies tend to be more volatile, but 32 of the 50 companies had negative returns during the period. In fact, 25 had declines greater than 10%, and 16 had declines greater than 20%.
I know this is only one illustration, and I may be oversimplifying a bit, but the point is simple: Lists are just basic screens in disguise and are not to be trusted blindly. They require critical analysis to unlock their value.
The first thing a good Fool should do is to make a fair critique of the list's context. Magazines are in the business of selling magazines. They want to publish exciting stories about companies in sexy industries. Value stocks in turnaround situations don't pull in the advertising dollars. As such, they will choose growth stocks over value stocks most of the time.
Which brings me to my next point. Although they might extrapolate to the future, lists are generally based on past performance; the companies they feature may have already seen their best days. It's unlikely to find a Hidden Gem in a list. But it's not impossible, as we shall see.
Because of this, the companies within the lists are arguably more likely to be overvalued. Buying overvalued stocks is playing "the greater fool" game -- buying a stock with hopes that later, another (greater) fool out there will buy the stock from you at a higher price.
Warning signsNow that we understand the context of the list, the next thing to do is look for signs of trouble. I don't know about you, but I find recent growth rates in revenue and earnings of more than 100% a little suspicious. In the 50 BusinessWeek companies, two had sales growth of more than 100%, while 13 had earnings growth of more than 100%. Universal Technical Institute (NYSE:UTI), a provider of automotive technician training, has grown earnings at more than 1,000% per year for the last three years! Remember that small denominators within growth rate calculations can distort the meaningfulness of the results. That's why Warren Buffett does not use Berkshire Hathaway's (NYSE:BRK.A) (NYSE:BRK.B) first year when calculating historical growth rates of operating earnings (see Page 4 of the 2003 chairman's letter).
Another warning sign is clustering. This is when multiple stocks within an industry make the list. This is fraught with peril. First, they can't all sprint through the marathon. Competitive pressures will begin to strain their ability to generate excess returns.
For-profit education grew quickly over the past few years, so it's not surprising that five of BW's Top 100 came from its ranks. But a rising tide numbs your ability to find the best operator in an industry -- the guy who will still be chugging after the rest of the fraternity has passed out. Recently, Corinthian Colleges (NASDAQ:COCO) suffered a major decline when enrollment rates changed from the trend, taking many in the industry down with it.
The last warning sign is high price-to-earnings ratios. The higher the ratio, the more you pay for your piece of the earnings generated by the company. As Fools, you know that P/E ratios by themselves don't mean much. But huge P/E ratios can indicate a bastion of irrational exuberance. People have a tendency to see the huge growth rates and the high returns and think, "I need to be a part of this." For example, the University of Phoenix Online (NASDAQ:UOPX) sports a P/E of 71. Is this justified because its earnings growth rate is 87%? Personally, I do not think so. At those rates, UOPX will soon be educating everyone in the country!
Using them to your advantageStock lists are a perfect way to sharpen your detective skills. Thinking critically is a Foolish quality, and you need to practice it often. Learning always creates value, even though it may be only intrinsic value at first. So put on your investigative journalism hat, pick a few companies from the list at random, and ask some basic questions. Do these companies have competitive advantages, and what are they? How are they going to generate future growth? Do their stories pass the sanity check?
Also, if a company strikes you as interesting or there is something you do not understand, use the Fool Community to find additional knowledge. The discussion boards make up an extremely valuable knowledge network that you should tap into before investing your hard-earned cash.
My experiencesWhile the odds are not in your favor, occasionally you can find some good investment ideas in the lists. I have had some fortune using the methodology, and I wanted to share it with you. I found Multi-Color (NASDAQ:LABL) this way and think it could be a good long-term investment. Middleby (NASDAQ:MIDD), a Hidden Gems pick, is on the list, but Tom Gardner found it awhile ago. Tuesday Morning (NASDAQ:TUES), a pick by James Early, is also on the list. So you see, with a little effort, it's possible to find solid investment ideas.
But many times my efforts turned up nothing, and you have to get into the mind-set that that is OK. Think about it. How many great investment ideas are there at any given time? Could a magazine really come up with 100 without much effort? Heck, Philip Durell and Tom Gardner can come up with only two ideas a month!
Final thoughts
Today, there is so much information out there that it is becoming riskier and riskier to take things strictly at face value. Screens and lists are useful starting points, but more work has to be done to determine whether a stock is a worthwhile investment.
Tom Gardner and Philip Durell always kick the tires before writing about a worthwhile idea. To see how much deeper they go, sign up for a risk-free trial ofHidden GemsandInside Valuetoday. And remember, Tom and Philip utilize the Fool Community to explore and refine their ideas. Sotap intothe Fool discussion boards to share and compare your thoughts with other Fools. Your portfolio will be glad you did.
Fool contributor David Meier's favorite list is David Letterman's Top 10 List. He does not own shares in any of the companies mentioned.
