The publicly traded companies that post strong revenue and profits growth for many years in a row have proved to be excellent investment. Holding one of these stocks in a portfolio can make all the difference between mediocre performance and above average results. Companies such as Microsoft, Wal-Mart and Starbucks have incredibly enriched their shareholders over the years.
Uncovering and investing in this kind of stock can be very rewarding but it should be understood that the strong growth won’t last forever. It is therefore important to determine in which phase of it’s “growth stock life” is a corporation. I have identified three major phases based on my personal observations:
1. The arising
This is the phase where the company experienced its first success and the beginning of its spectacular growth. Nevertheless, the stock is still unknown and is not often the subject of articles in the financial press. This is obviously the best time to buy but it’s also the riskiest. The future looks very promising but the company still has to demonstrate it has the ability to maintain a high growth rate for a long time and that its initial successes are not just fleeting fireworks.
2. Celebrity
After several years of spectacular growth, the stock is now known to all and the financial press is singing its praises. The company is admired and its price/earnings ratio is proportional to the level of admiration (read: very high). Many investors dare not buy it because of its rich valuation. The corporation punishes their lack of courage by continuing to deliver strong results that drive up the price of its shares at levels never seen before.
3. The decline
Curiously, the price/earnings ratio recently declined and is now more in line with the recent years growth (example: a 25 pe ratio for a 25% growth). Many investors see that as an opportunity to invest in a company of high quality at a reasonable price at last. Unfortunately for them, the strong growth of the company is nearing completion. Over the coming years, they will observe a continuous contraction of pe due to the growth deceleration. Worse yet, the company must deal with a bunch of problems it had neglected during his fabulous expansion. The share price has stagnated (at best) or is greatly reduced.
In short, the arising phase is still the most rewarding but also the riskiest. The celebrity phase is less risky because the company is firmly established, but this certainty has a price. Moreover, there is always the risk that the company is at the dawn of its decline. The transition from celebrity to decline is often a little fuzzy. The stock is not loved unanimously like it was before but still has many admirers. A clue of this transition is that the company engages in short-term operations to maintain its growth in earnings per share at any cost.
In conclusion, owning for several years a high growth stock is a memorable experience for all investors. However, it’s no time to rest on our laurels for that growth will not be eternal. We must continue to monitor the business closely and be alert to early signs of decline.
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