As an investor, you should always be looking for growth. Share prices tend to follow a company's value, so investors should seek companies that are increasingly more valuable -- growth companies. The truly phenomenal stock market returns are made by holding onto superior companies that grow relentlessly for decades.
But to actually identify the best growth stocks, you have to take a step beyond looking for the companies with the highest projected growth rates. After all, if market starts to lose faith in the company's prospects, the fall can be horrendous. Just look at XM Satellite Radio's (NASDAQ:XMSR) performance over the past year.
So, 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
It might seem a bit obvious to anyone who has passed toilet training, but the most successful growth stocks are the ones that, well, grow. And all else being equal, fast growth is generally better than slow growth. Because of compounding, even relatively small changes in growth rate can mean a big difference to investors.
In the last 10 years, Harrah's (NYSE:HET) has grown its revenue from to $1.6 billion to $9.4 billion, roughly 19% annually. MGM Mirage (NYSE:MGM), on the other hand, grew its revenue from $800 million to $7.4 billion -- an impressive 25% rate. As you might expect, investors did better in MGM. A $1,000 investment in MGM grew to $5,600, while Harrah's returned $4,800.
2. Sustainability
But to achieve truly great results, you need to look beyond growth estimates. One of the biggest blind spots for most growth investors is focusing on the growth rate and ignoring the sustainability of the 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.
You should pay as much attention to the competitive position of the business as you do its the rate of growth. eBay (NASDAQ:EBAY) prospered throughout the tech bust because it had networking effects that kept competitors away. Sellers wanted to list on the website with the most potential buyers, and the buyers wanted to buy items on the site that offered the widest selection. Thus, once eBay had established itself, it was very difficult for anyone else to compete. Similarly, Wal-Mart has enjoyed incredible success by focusing on one important sustainable competitive advantage -- selling at the lowest possible prices. And shareholders have ridden that advantage to handsome profits. If you invested $1,000 in Wal-Mart in 1980, you would now have $239,708 before dividends. Now, that's been great sustainable growth.
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 Amazon.com (NASDAQ:AMZN), for example. The best-known Internet retailer has sustained its growth despite the tech meltdown. Yet the stock is far below its highs, mainly because it was so overpriced during the tech bubble that no amount of performance would have kept propelling it up. Microsoft (NASDAQ:MSFT) is in the same boat. It's the most dominant tech company of all time, but five or six years ago, it was trading at completely unreasonable multiples for such a big business. Consequently, the stock has been flat for years.
So, before buying a growth stock, make sure that it's undervalued, or at least fairly priced. A great way to work out the fair value of a growth company is by using a discounted cash flow calculation, since these formulas will take the company's growth into account. If you don't know how to do these calculations, the Motley Fool Inside Value newsletter has an easy-to-use discounted cash flow calculator here for subscribers (a free trial is also 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 Buffett, we prefer to purchase strong companies with excellent growth prospects because we recognize that such companies are worth significantly more than weaker companies. At the same time, value investors also know that if you overpay for that growth, then you're both increasing risk and reducing potential profits.
Thus, 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, so it pays to constantly be on the lookout for these businesses. Such companies 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". He does not have a position in any other security discussed in this article. Microsoft and Wal-Mart are Inside Value recommendations. eBay and Amazon.com are Stock Advisor selections. XM was once a Rule Breakerspick. The Fool has a disclosure policy.
