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Stock Strategy: Hot-Growth Leaders

When it comes to stocks, growth is the name of the game. It has to be. Stocks have to compete with fixed income, where you have an easily-recognized yield and risk that ranges from zero to modest (relative to equities). Meanwhile, many stocks have zero yield and among those that do feature dividends, yields don't impress compared with fixed income. So if you're going to be in stocks, you have to expect much of your return to come from capital gains, and that generally requires growth.

But that's not the end of the discussion. There are many ways to measure growth. Which items should one look at? What time periods should one consider? And what criteria should one use to determine whether or not a particular growth rate is desirable.

This particular Portfolio123 screen works with EPS, the basic measure, and with Sales. The latter is important: We certainly like to see EPS growth, and we appreciate margin improvement, share buybacks,, and other strategies that can help EPS grow faster than Sales. But we don't want to overdo that sort of thing. Ultimately, if a company is to really grow, it will need strong trends on the top-line as well.

When it comes to the periods over which growth will be measured, there's much room for debate. The classic answer would be to favor longer-term growth rates, those that demonstrate the sustainability of the company's strength and weed out flash-in-the-pan firms. And that approach does work well. Interestingly, though, shorter-term periods can also prove fruitful. This screen favors the latter thereby piggybacking on Wall Street's usual here-and-now focus. We can afford to do that because the screen is being used in conjunction with the Balanced Fundamentals Ranking system. The latter will suffice quite well in weeding out firms whose growth numbers owe more to good luck than to good management.

As to determining when a growth rate can be considered good, use of a numeric threshold is not always best. A five percent growth rate sounds unappealing at first glance. But if we're talking about a recessionary period and, perhaps, a company in a cyclical industry, five percent could, actually, be excellent. This screen measures a company's growth rate relative to industry peers and requires each company to be in the upper half. We'd rather not push too much higher than that because growth extremes are rarely sustainable. We'll instead aim high when we use the Balanced Fundamentals ranking system to identify the best stocks from among those that make the screen. It's more comforting to go to the top of this sort of list because it is much more broad based.

The specific screening tests, applied to a universe consisting of non-OTC stocks priced at or above 5 and with market capitalizations of at least $250 million, are as follows:

  • EPS Growth in the latest quarter (the year-to-year comparison) ranked in the top half relative to industry peers
  • Trailing 12 month EPS growth ranked in the top half relative to industry peers
  • Sales Growth in the latest quarter (the year-to-year comparison) ranked in the top half relative to industry peers
  • Trailing 12 month Sales growth ranked in the top half relative to industry peers

Among stocks that pass these tests, we started by selecting the top 10 based on the Balanced Fundamentals ranking system, that being consistent with what most investors could very comfortably research and/or trade.

Figure 1 and Table 1 show the results of a Portfolio123 backtest of this screen from 3/31/01 through the present. It assumes the screen is rerun, and the list refreshed, every four weeks.

Figure 1

Like most stock-selection approaches, this one struggled during 2007-08. But I've seen many others that suffered more, and on the whole, this strategy beat the S&P 500 with plenty of room to spare.

Moreover, with a strategy like this, we don't absolutely have to confine the list to 10 stocks. For those who would like a greater variety of ideas, the backtest summary in Table 2 shows that we can easily expand the list to 25.

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