Wednesday, February 28, 2007

How to select growth firms

Lately, companies that reported strong growth in sales and profits were rewarded with higher stock prices. Hence, analysts and investors are currently paying close attention to the latest financial results announcements, hoping to catch those stocks early at a low price.

Benjamin Graham defined a growth company as a company that has performed better than the industry average over a period of years and is expected to continue to do so in the future. As earnings potential is the primary driving force in stock prices, our focus will be on the potential growth in earnings, which has yet to be reflected in the current price.

When investors invest in growth companies, they are hoping to invest in companies with products or services that are in high demand and have an edge over the competition.

According to W. Chan Kim and RenĂ©e Mauborgne in their famous book, “Blue Ocean Strategy'', companies in blue oceans, where there is still ample untapped market space, have the highest opportunities for demand creation and profitable growth. Normally, they tend to be the best among their industry peers and place equal emphasis on value creation and innovation.

According to Warren Buffett, growth companies have long-term pricing power and sustainable moat. The long-term pricing power refers to the ability to increase prices even when product demand is flat or the ability to achieve large volume increases with only small additional capital investment.

A sustainable moat is regarded as the entry barrier that current competitors and potential entrants find impossible to break. Companies with the above two characteristics will normally show high growth in sales and good profit margin.

Recently, companies with great businesses and fast growth were traded at price levels that might not be unsustainable. Investors need to pay attention to the price that they pay and the expectation of future growth. In reality, it is impossible for a true growth company to exist for an infinite time period in a relatively competitive economy.

Therefore, the entry price for a growth stock is crucial. The time to purchase is when it is still on sale, and not when it’s already at the peak where everyone seems to own a piece of it.

How do I know whether this stock is considered a growth company?

One of the common methods used by analysts for identifying growth companies is by tracking the company’s quarterly financial results. Again, strong sales and profit growth are the two most important characteristics of a growth company. If a company is able to show consistent growth in sales, this implies that it is expanding its production capacity and activities.

The table shows the quarterly financial results of Tong Herr Resources Bhd. Over the past three quarters, from Q106 to Q406, it reported strong growth in sales and profits on a quarter-on-quarter basis as well as year-on-year basis.

As a result of lower profits reported in Q205, Q305 and Q405, its stock prices tumbled from a high of RM4.30 in early 2005 to a low of RM2.30 in February 2006. Since then, due to the strong growth in sales and profits, its share price has recovered to the RM4-level again recently.

Investors need to study a company’s financial performance to determine whether the potential of future growth has been fully reflected in its current stock price.

As a result of the extrapolation of the recent performance, when the market is already high, our analysis will tend to be over-confident, which would lead to the decision to buy or sell stocks at the wrong time.

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