Streetwise for Sunday, April 28, 2017
When the markets become frothy, it is not unusual for terms like growth stock, cyclical stock and stock of a growth company, to be thrown about indiscriminately. While not an all-encompassing categorization, keep in mind that companies in these various groupings have distinctly different investment characteristics. Here is how I would define them.
A growth stock is the common stock of a company whose growth exceeds both the economy and the normal growth pattern for that company’s industry. Many of the more popular growth stocks belong to household names such as Walt Disney and Pepsi. Companies of this ilk are probably in the middle-to-late-stages of their expansion phase.
The earnings growth at these companies is generally predictable and they generally can maintain it, even when the economy stalls. Growth stocks usually pay smaller dividends, as the company typically reinvests retained earnings in capital projects.
Since analytical coverage of the more popular growth stocks is extensive, they are often recognized as being fully valued. This means they are trading at prices in line with the streetís consensus numbers.
On the other hand, growth companies are those companies that exhibit rising returns on assets each year and their sales revenues are continually growing at an increasing rate. They are often found in industries such as computers, medical electronics, and telecommunications.
Growth companies do have potential risk from an investment point of view. Ebullient extrapolations of the statistics for a growth company can lead to very erroneous results. Do not let excess optimism bias your analysis. However, the kind of risk attributable to growth companies can also mean unusually high returns if you do your homework diligently.
There are several characteristics that are common to most growth companies. For example, they often have a proprietary product that is patented and thereby protected from competition. This market protection allows a high rate of return and generates cash for continued new-product development.
An excellent place to begin looking for growth companies would be in the high-tech arenas. However, keep in mind that few sectors have as great a volatility factor. One reason is that companies in these sectors have seen the life span for many of their products shortened due to competition and patent expiration.
The intense competition has also resulted in profit margins being continually squeezed. Still, stocks in these sectors have been stellar market performers.
There is one characteristic that is critical to the analysis of both growth stocks and stock of growth companies, their reliance on research and development for both growth and survival. These companies can only lengthen their expansion phase by bringing to the marketplace new and/or improved products.
The third category is cyclical stocks. These are companies whose fortunes are directly tied to the economy. Typically, these companies sell discretionary items that see greater demand during an expanding economic cycle and less during a recession. In contrast, non-cyclical or defensive companies, such as food companies and utilities, maintain profitability regardless of the economyís gyrations.
Recognize that many stocks will often move up or down as part of an industry group because of beliefs in the group as a whole. Therefore, the wheat is trampled along with the chaff. It is rare to see one stock rise out of a neglected industry group and turn in an outstanding market performance. The stock will generally have to wait for the entire industry group to come out of the doldrums before regaining its wings.
This means is that some excellent investments will be bypassed because they are part of a lagging industry group and investors will often ignore all companies in an out-of-favor group. However, if you are bottom fishing then a stock that has been unduly stigmatized by the company it keeps is made to order.
Lauren Rudd is a financial writer and columnist. You can write to him at LVERudd@aol.com. Phone calls accepted between 9 AM and 3 PM at (941) 706-3449. For back columns please go to www.RuddReport.com.