Investors that focus on fundamentals tend to have a bias towards value investing when looking for potential trades. Growth investing is another major school of investment theory that relies on analyzing the fundamentals. One way to understand the difference between the two can be put this way. Where value investors might look for bad news they think will improve, growth investors look for good news they think will get better.
Growth investors are especially looking for companies that have accelerating earnings which are ahead of their industry group. The idea is that companies grow their earnings faster than the market over a long period the stock price will rise faster than it will for slower growing companies or the market in general. So growth investing is just another facet of value of value investing. Instead of looking for companies that are undervalued relative to their assets and current earnings, growth investors look for companies whose future prospects and earnings are being undervalued by the market.
There are a number of growth strategies that are designed to outperform the market. Peter Lynch was a famous growth investor who helped make putting money into mutual funds exciting. He did that by a combination of great returns for his Fidelity Magellan Fund and a straightforward way of explaining what he was doing that was popular with middle class investors.
Lynch had a number of criteria he used when choosing investments. He looked for company's whose earnings per share were growing between 25-50% per year and stayed away from those growing more then 50%, feeling that was too fast to be sustained. He also used the PEG ratio, which is the P/E ratio divided by the rate of growth in a company's earnings. P/E ratios are higher than they used to be, so it can be difficult to decide what an acceptable number is now. Since there are big differences between different industry groups, I would suggest comparing it to the average for that sector.
On top of those criteria he used a few other rules of thumb. He was well known for only wanting to invest in a store or product that he liked. But he also had some more unusual rules, such as only wanting to invest in a company if their annual reports had a minimum of pictures in it. He also preferred that a company's inventories stay even with sales, since he saw inventories that were increasing faster than sales as a red flag.
Another well-known growth investor is Martin Zweig, who became famous after predicting the Crash of 1987 on the Friday before it actually occurred. He likes to see the rate of increase in a company's earnings be relatively stable, such as a 20% increase in each of the preceding three quarters.
Like a typical value investor, he doesn't like a company that has a lot of debt. For the P/E ratio he wants companies that have a P/E higher than 5, but not more than three times the current P/E for the overall market. He also looks for earnings growth that is accompanied by higher revenue growth as well as an increase in annual earnings for each of five years.
To get a good understanding on how to use the fundamentals for growth investing, I would recommend reading the classic book “How to Make Money in Stocks: A Winning System in Good Times or Bad” by William O’Neil. This book covers a growth investing system known by the acronym CANSLIM. Each letter stands for a specific fundamental or technical factor. Those factors are:
- Current quarterly earnings per share: What is the right amount?
- Annual earnings increases: Look for meaningful growth.
- New products, new management, and new highs: buying at the right time.
- Supply and demand: small capitalization plus volume.
- Leader or laggard: Which best describes the stock?
- Institutional sponsorship: A very good sign.
- Market direction: How should it be determined?
Developed by studying past leaders in the stock market, CANSLIM is a strategy that gives strict disciplined investing rules for buying, selling, and holding stocks. One big advantage of the system, absent in many other growth investing strategies, is that it forces an investor into cash when the market is not optimal for holding stocks.
While there are many rules to apply in this investment system, I like the top-down approach which first examines the stock market in general to determine whether it is technically a good time to invest. This system also recommends you buy stocks on their breakouts above resistance levels, typically when they are approaching new highs.
The style popularized in Investors Business Daily is based on this approach, with a breakout defined as a stock price increase to new highs on trading volume that is well above the average volume for the stock. In fact, the newest edition of the book has a section explaining how to use their investors.com website.
Finally, to protect an investor from risk, the system stresses placing stops 7% to 8% stop below the pivot, or buy, point. This prevents you from riding a stock all the way down, as many investors did when tech stocks crashed in the early part of this decade.
Because the stocks in growth funds tend to be expensive (meaning they have a high P/E ratio), growth investing is generally considered riskier than the value investing style. Growth funds also tend to be more volatile than value funds. Both styles can produce strong results – or fail to – but rarely at the same time. Value investing tends to pay off during bear markets when stock prices are depressed, while growth investing works best in quickly rising bull markets.