How to Know You’ll Pay the Right Price for High-Growth Stocks

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Glamour stocks (aka high-growth stocks) often dominate the headlines.

You see, when scholars first discussed the value approach to investing in the academic literature, they used the label “glamour” for stocks that were the opposite of value stocks.

These were popular, much-hyped stocks that everyone wanted to get into … thus, investors were willing to pay just about any price for them. This made them expensive.

But now, “growth” has replaced the “glamour” label.

That pitted “value” and “growth” against each other as if they were diametrically opposed … two ends of the same spectrum.

If you’ve let Wall Street convince you that you must choose between “cheap” value stocks and “expensive” growth stocks … well, that’s a false choice.

We can (and do!) buy fast-growing companies for good prices.

Consider what Warren Buffett has said on the topic:

Growth is simply a component — usually a plus, sometimes a minus — in the value equation.

To me, here’s what that means:

  1. It’s possible to find “value” companies irrespective of their “growth” characteristics, which sometimes detracts from the company’s value but other times adds to it.
  2. Buffett said growth is usually a plus. I interpret that to mean, all other things being equal, it’s better to invest in a company with higher growth than lower growth.

GARP Investing: A Matter of Degree

Another way to think about the intersection between value and growth is the acronym and investment approach popularized by legendary fund manager Peter Lynch: GARP, or “Growth at a Reasonable Price.”

This approach begins by assuming that it’s better to invest in a company that’s growing sales and earnings at a higher rate than the overall market. However, there’s a limit to the price you should pay for these companies.

If you overpay a little for high-growth companies, that’s OK. You can still look forward to beating the market with them.

But if you pay far too much, you won’t. It’s a matter of degree.

Neither Buffett nor Lynch are what we’d call “quant factor investors.” They just understand that high-growth companies are favorable — as long as you don’t pay nosebleed valuations for them.

I hope it adds confidence to our approach, knowing that these two titans understand and capitalize on the Growth factor.

But let’s also consider what the quantitative academic research says about growth.

For that, we can do what are called factor regressions.

These take the bucket of companies that we can label “high growth,” and then determine how the stocks look on each of the other factors:

Said another way: Where is there “overlap” between the growth factor and each of the other factors?

Now, research has shown a positive overlap between growth and momentum, and between growth and quality.

This means that, typically, high-growth companies rate highly on the Momentum and Quality factors.

Conversely, high-growth companies typically rate a bit below average on the Value, Size and Volatility factors.

So, we can say that, relative to low-growth companies, high-growth companies tend to have the following:

  1. Low leverage and high profitability (i.e., good quality).
  2. Strong stock price performance (i.e., high momentum).
  3. Slightly expensive valuations.
  4. Larger market capitalizations.
  5. Higher share price volatility.

Why Buying High-Growth Stocks Works

To me, two solid explanations tell us why growth investing works (and why a stock’s Green Zone Growth score is important).

1. I’ve explained how both the Green Zone Momentum and Green Zone Quality factors have strong behavioral reasons for their efficacy. Since the Growth factor positively correlates with these two factors, we can assume that growth investing works because investors consistently underestimate how much a high-growth company will continue to grow.

2. I think there’s a strong economic explanation for high-growth investing when you simply consider the most fundamental definition of stock ownership…

Owning shares of a company’s stock gives you, the shareholder, claim to the future earnings of the company.

And logically, if those future earnings are getting bigger over time, then your claim to that cash flow is also increasing in cumulative value.

Consider Stock A or Stock B, each for $10 a share.

Wouldn’t you prefer to buy Stock A if it promises to hand you $1 per share in earnings next year, $2 the following year, and $3 the year after that over Stock B, which may only hand you $1, $1.10, then $1.20 in the same time?

This understanding is intuitive to most folks. But again, the price you pay for that “high-growth” company is important. History proves that you may have to pay a bit more for a high-growth company — and if you do, that’s typically OK, as many high-growth companies end up being worth it.

But the trick is not allowing yourself to get so caught up in the growth story that you end up paying any astronomical nosebleed price the market may ask for that stock, at the height of the public’s frenzy for it!

Why Green Zone Ratings Is So Valuable

And this is where having a multifactor rating model is so valuable.

That’s exactly what we have with Green Zone Ratings — which is absolutely free for you to use, no strings attached!

My six-factor Green Zone model rates stocks on growth metrics, including sales, net income and earnings-per-share growth rates, over multiple time frames. This helps me find the market’s high-growth companies.

But it also rates stocks on value, size and volatility as countermeasures, so to speak, to a stock’s growth rating.

For example, if Stock A rates a 99 out of 100 on growth, but otherwise rates a 5, 10, and 15 on value, size and volatility … the stock’s overall score will be much lower than a more well-balanced stock…

And Stock B may rate an 85 on growth, but also rate a 60, 70, and 80 on value, size and volatility … making this stock’s overall score much higher.

All told, my model identifies stocks that are well-balanced across all six factors. This ensures that, among other measures of balance, if we’re buying a high-growth company … we’re also paying a “reasonable price.”

Keep in mind: My team and I publish my Top 10 Watchlist on www.moneyandmarkets.com every week! You can see the latest watchlist here.

The list shows you every stock’s overall Green Zone Rating. And remember: You can use the Green Zone Ratings system to look up each stock to examine the numbers further.

If you want to get my latest hand-picked Green Zone stock, make sure you check out our Millionaire Master Class today.

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And you’ll get my brand-new stock pick: a little-known American company that rates a 97 overall! It rates a 94 in Value, a 90 in Quality, a 75 in Growth … and I’m releasing it today!

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To good profits,

Adam sig

Adam O’Dell, CMT

Chief Investment Strategist, Money & Markets

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