A checklist for finding growth stocks
My starting point for identifying growth stocks is always a financial checklist. I set up a screen to narrow down the market, before moving onto a more qualitative review of the characteristics I look for in a possible growth investment.
It’s worth pointing out that the financial metrics I discuss below aren’t cast in stone. They are simply generalities that I find to be useful as a source of plausible ideas for further research.
Narrowing down the market
If I’m focused on growth stocks, then I’ll start by narrowing down the market by size. I will also rule out companies that show obvious signs of being unable to fund their own growth, as I’m only interested in businesses that are profitable and largely self-funding.
I have two rules of thumb to achieve this:
1. Not too big, not too small: to avoid speculative micro caps and more mature businesses, I generally narrow down my search to companies with a market cap of between £25m and £1.5bn.
2. Self-funding growth model: I want companies that have reached a stage of sustainability that allows them to fund growth through retained profit and perhaps some debt. I don’t want to invest in companies that depend on regular share placings to raise cash.
As an initial test, I’ll check the share count history to see if shareholders have been diluted in recent years.
Growing and profitable
I’m not looking for early-stage businesses that are speculative or loss-making. Such companies require in-depth research and a different approach to managing risk, in my view.
The growth businesses I look for are already profitable, with proven business models. The opportunity I seek is to find companies with the potential to become much bigger – and preferably much more profitable.
As Stockopedia’s Multibagger research highlighted, the combination of rising profits and expanding profit margins can drive exceptional share price gains.
Understanding a company’s growth potential requires a look at the business itself. But to narrow down my search to a more manageable short list, I start with a number of quick financial checks. These can be carried out using the StockReports, or even automated with a screen.
Revenue growth & rising margins: I like to see historical revenue growth of at least 10% per year, ideally over several years. This tells me that the business is increasing its sales substantially ahead of inflation – real growth.
I am also looking for companies that can benefit from operating leverage. This means their operating margin will rise as sales increase and fixed costs account for a smaller fraction of total revenue.
In the image above, we can see this visually. The operating profit growth rate (CAGR) is higher than the revenue growth rate. This tells us profits have been rising faster than sales, expanding the company’s operating profit margin.
Operating margin and ROCE: if a growth company is still at a relatively early stage in its journey, profit margins may not have reached their full potential.
As a starting point, I look for a minimum operating margin of 5% and a minimum return on capital employed (ROCE) of 8%.
I choose a ROCE of 8% because this figure is often used as a baseline estimate for the cost of capital of a business. I want to find companies that are already generating returns above their cost of capital, in order to demonstrate the validity of their growth model.
(If you’re not familiar with the importance of return on capital employed, I’d strongly recommend Ed’s guide to this important ratio here.)
In reality, I’m really looking for margins and ROCE comfortably above my minimum requirements. But if the company is still relatively small, I’m willing to accept lower profitability if I believe that the business can deliver strong operating leverage.
The reason for this is that improving profitability and consequent multiple expansion can be powerful drivers of share price gains.
For the company featured in the operating margin chart above, rising margins have supported an impressive increase in ROCE.
And here's a chart of same company's share price over the same five-year period:
Evidence of momentum
Value and quality investors often dismiss momentum, but the evidence shows it can be a powerful and persistent force.
It's useful to consider both earnings and share price momentum.
1. Earnings momentum: are earnings per share expected to rise – and are broker forecasts being upgraded?
2. Price momentum: The main momentum metric I look at for growth stocks is relative strength, which is a measure of whether a stock is beating the market. I tend to use six-month relative strength as this has been shown to be a useful indicator of near-term outperformance.
I also like to see the 50-day moving average above the 200-day moving average.
Strong fundamentals
Strong growth is not an excuse for a weak balance sheet or poor cash conversion. Indeed, Stockopedia’s multibagger research shows that the top–performing UK stocks in the last decade all operated with low levels of debt and demonstrated good cash generation.
In my initial review, I like to keep things simple by using two metrics (both of which can be found on Stockopedia's StockReports).
1. Piotroski F-Score: this fundamental health score looks at profit growth, cash conversion and leverage. It’s a useful snapshot of whether a company’s accounts are moving in the right direction.
2. Net gearing: this measure compares a company’s net debt with its shareholder’s equity (book value).
This measure can be influenced by factors such as lease debt and pension liabilities, but in general I prefer to see net gearing under 50% for growth stocks. A negative number indicates net cash. This is the ideal scenario for me.
Valuation: how much to pay?
How much should we pay up front for expected growth? It’s a perennial question with no single correct answer.
One useful tool is the PEG ratio, or price-to-earnings growth ratio. This was made popular by famed growth investors Peter Lynch and Jim Slater and is discussed by Slater’s fund manager son Mark in this Stockopedia interview.
Companies with strong earnings growth can look expensive on a trailing P/E ratio, but may look more reasonably priced based on forecast earnings.
The PEG ratio divides a company’s historic P/E ratio by its forecast earnings growth rate. This effectively normalises the P/E to reflect expected growth. It’s a useful tool for comparing companies with different earnings growth rates.
A PEG ratio of less than one is generally seen as being cheap. When I’m screening for reasonably-priced growth stocks I tend to set the PEG to 1.2, in order to avoid being too restrictive.
Dividends: one final point related to valuation is that I like to see a small dividend from growth stocks. This is a somewhat controversial topic.
I accept that in theory, it might sometimes be more logical for a growth company to reinvest all of its surplus profits.
However, my view is that the dividend provides useful evidence of both cash generation and capital allocation discipline.
What I mean by this is that paying a dividend is likely to force management to prioritise growth opportunities, in order to maintain the shareholder payout. I think this can be positive.
I want the managers of my companies to have to think hard about how to allocate capital and only choose the best opportunities. I don’t want the cash hose aimed at every possible opportunity.
Interestingly, all of the UK companies that featured in our study of top multibaggers from 2013-2023 paid dividends.
Understanding the business model
You’ve found a company whose financial performance suggests it could be a genuine growth stock. Better still, you’ve built a short list of potential investments for further research.
What next?
Promising growth stories can sometimes fade away because the underlying business does not have the qualities needed to deliver sustainable, profitable growth.
That’s why my priority at this stage is to spend some time learning more about the business and asking some important questions. Here’s an overview of the main areas I focus on.
What does it do?
This may sound basic, but in my experience it’s quite easy to reach a point where you are attracted to a stock without having a very good understanding of what the business actually does!
Companies don’t always help themselves here. All too often, RNS releases are laden with PR-speak and business jargon, instead of simply stating what the company does in plain English.
B2B software companies are among the worst offenders, but even building products can be problematic. Why talk about “engineered fenestration components” when you could just say doors and windows?
To learn about a company’s business, I’d start with its website and annual report. Broker notes can also be a good source of information about the company’s main activities and are often available on Research Tree.
For a broader view, consider news reports, online reviews and perhaps trade journals.
Understanding the growth potential
When I have a good understanding of the business, my next step is to try and understand the size and profitability of the growth opportunity – and whether the company is likely to have any durable competitive advantages.
Sales growth runway: as I mentioned in the financial checklist, rising revenue is essential. If sales are not rising ahead of inflation, then the business is probably not growing.
Broadly speaking, there are three routes to sustainable sales growth companies can employ. Ideally, I like to see at least two of them in a strong growth opportunity:
Enter new markets, either geographically or through new customer segments
Sell new products or services into existing markets. These might be periodic upgrades, or new products that sit adjacent to existing offerings and will generate additional revenue from existing customers
Gain market share – are the company's markets fragmented or already highly concentrated in the hands of a few large suppliers? What's the existing market share of the business? Is it competing on price, quality, or some other factor?
By learning about a business, I try to understand which of these options apply to the company I’m looking at. If none of them are, I’ll probably rule it out.
Profitability of growth model: I’ve already looked at profitability metrics and checked whether there’s any evidence of operating leverage.
Next, I want to understand more about how much the company might need to invest to continue growing, and whether further growth could compromise profitability.
Does the business have a capital-light business model that can support additional customers or sales without too much additional investment?
Or does adding new capacity require high levels of capital expenditure?
For example, a company that manufactures widgets in its own factory may need to build a second factory if demand takes off. This could dampen profitability for several years until the new factory is fully utilised.
In contrast, a software business or a firm that outsources its manufacturing can typically add capacity with much lower levels of upfront investment (although outsourcing carries its own risks).
During its initial growth phase, premium mixer company Fevertree Drinks (LON:FEVR) was able to expand quickly and generate high returns on capital because it outsourced production of its drinks. The company’s focus was on product development and marketing – both capital-light, scalable activities.
Capital-intensive businesses can still deliver attractive long-term returns. But all else being equal, a capital-light business is likely to deliver stronger operating leverage and more rapid profit growth.
Competitive advantages? Why should customers choose this company’s products or services – and will this competitive appeal remain durable into the future?
Warren Bufffett looks for businesses which have an economic moat – the term the Sage of Omaha uses to describe a durable competitive advantage. We discuss the different types of moat in more depth here, but in short, they tend to fall into one of these categories:
Intangible assets, such as brands or intellectual property
Network effects, where a service is more valuable to customers if more people use it
Switching costs, where it’s difficult or expensive to change supplier
Economies of scale, or cost-advantaged assets
Superior processes or services that competitors cannot easily replicate
Management: investors in FTSE 100 shares have come to accept highly-paid management with minimal shareholdings as the norm.
But investors in smaller growth companies often rightly (in my view) prefer to see management who are modestly paid but own significant shareholdings. This helps to align management with the owners of the business – something that’s not always the case.
Other factors relating to management that I find to be useful indicators are the quality and consistency of the company’s reporting:
Do they track consistent metrics that provide a meaningful measure of growth and value creation?
Or do they rely on an ever-changing mix of adjusted profit metrics?
Is reporting timely or left until right before the regulatory deadlines?
Do management give a clear account of problems and answer investor questions freely in webinars?
We discuss management credibility in more depth here.
What can go wrong?
It’s essential to build a portfolio with the expectation that some investments will lose money.
Problems are inevitable in growth businesses and can be due to both internal and external factors. Here are a few examples of the kinds of risk that may be worth considering:
Cyclical exposure – this isn’t always obvious until a downturn strikes
Customer concentration
Single points of failure, e.g. one factory in China producing all products
Key person risk
Geopolitical risk
Regulatory risks
Financial mismanagement
This isn’t an exhaustive list, but hopefully it’s a useful starting point.