Growth stocks can sometimes make for terrible investments. And believe me, as an aggressive growth stock strategist, I know. The problem is that hefty growth rates are just not enough to keep a stock’s price rising.
In fact, if you break stocks into groups based on their expected EPS growth rates, you will be startled. There is actually an inverse relationship between projected earnings growth and stock price returns. Meaning stocks with the highest earnings growth rates actually have the lowest share price performance.
When 5% Beats 50%
The only way to keep these stocks rising is if the growth rates continue to improve. How else can you explain blue chips with a boring 5% growth rate outperforming a biotech company with a 50% growth rate? It happens all the time.
Here is the problem. When a high growth company is expected to increase earnings by a whopping 50%, then the share price rockets up given those lofty projections. If that growth rate falls, even just a little to 40%, you better believe the stock price is coming down…fast.
But do not fret. There are surefire ways to not only break this trend, but reverse it. If the method didn’t work, well, I’d be out of a job. Essentially, there are 3 common pitfalls to growth stock investing that are eating away your profits. See them all below along with advice on how to avoid these mistakes.
1) Buying Too Late
While arriving late is “fashionable” for a cocktail party, it is an easy way to demolish your portfolio. Far too often people get attracted to a growth stock after it has already made a huge run up. This bandwagon effect leads to a stock being “priced for perfection” as can clearly be seen by a lofty Price to Earnings (P/E) ratio. Anything less than perfection in upcoming earnings reports will quickly lead to massive losses for shareholders.
The cure for this is to first make sure that earnings estimates are still on the rise. This is your best defense to confirm that “in the know” research analysts still think that growth prospects are on their way up. Second, use some reasonable valuation metrics like PEG to make sure you are not overpaying for the growth prospects.
2) Don’t Overstay Your Welcome
Holding onto a stock too long is probably the most common mistake growth investors make. You love the story. The growth rate is still high. But the stock keeps falling because other investors “just don’t get it”. Sound familiar?
The problem is that institutional investors know what’s wrong with the stock and have already taken action. And what’s wrong is that the growth rate has slowed and shares are simply not worth as much. Once that party starts, it usually continues for a long time. Kind of like how Microsoft grew profits for 5 straight years and yet the share price went nowhere because the growth rate slowed down.
Your best defense on this front is to look for signs of a slowing growth rate. This can be seen by decreases in earnings estimates or by a lowering of the long term growth outlooks provided by brokerage firms. The first sign of these things happening is your signal to pack up profits and move on.
3) The Price has to be Right
Even if you are not a classic value investor, there is simply no good reason to pay more than you have to for a stock. Don’t fool yourself with proclamations like “But it has a great story!” Guess what, so does the next stock and you can get it for half the price.
Too often we are lured into a stock because of fantastic growth potential and throw valuations out the window. I agree that the stodgy P/E ratio may not capture the whole story, but there are other metrics that do.
The PEG ratio, or P/E divided by the growth rate, should always be considered. After all, we are buying these stocks because of their earnings growth rate, so we better make sure we are getting those rates at a good price.
For smaller companies, which growth investors usually target, I look to the price-to-sales ratio as well. Earnings for smaller companies can be quite volatile for many reasons. But the sales will tell a better story of the companies’ performance.
With that being said…
Where Can You Find Growth Stocks that Make the Grade?
Now that we have those three pitfalls covered, its time to start avoiding them in your own portfolio. Keep just one in mind and you are ahead of the game. Avoid all three and you’ve got a recipe for market-beating returns.
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Best Regards,
Bill Wilton
Bill Wilton is the Growth Stock Strategist for Zacks.com. He is also the Editor in charge of the market-beating Zacks Growth Trader.
