This is Part 2 of a series of posts that I’m writing to share my process for selecting and investing in growth stocks. Part 1 was just a short introduction. In this post, I’ll focus on how I find growth stocks to analyze. I’m looking for stocks that I believe will outperform the market. On second thought, I just set the hurdle a bit too low. I’m actually looking for the companies whose stocks will offer me the best possible returns. However, my degree of certainty about a particular company’s prospects is also highly important; there are a lot of companies out there that might have the potential for greatness but still retain a lot of risk for investors. I tend to avoid most of these. Let me elaborate on what I avoid and why.
COMPANIES THAT I TEND TO AVOID
I usually avoid investing in companies that remain unproven in one or more aspects that are required for the thesis to play out. There are several kinds of risk including the following:
Market risk: is there a market
Product/service risk: will the company’s product(s) and/or service(s) fit the market’s needs in order to be successful
Financial risk: does the company have enough capital or will it run into difficulties raising additional capital need to fund its development
Execution risk: does the company have a proven management team, and will they be able to execute successfully on the company’s mission
Customer concentration risk: does the company have the bulk of its revenue tied to one or a handful of customers
Disruption risk: is the company at risk of being easily disrupted
Key man risk: how dependent is the success of the company on a founder or key employee
The preceding list is by no means comprehensive, but any one of these risks, if worrisome to me, could be grounds for elimination from candidacy in my portfolio.
Now I’d like to discuss a few specific types of companies that may seem enticing, but I would deem too risky to include in my portfolio.
Microcap or even smaller companies
For several years, I was a member of an angel investing group of 30-40 investors. We analyzed very early-stage companies that were usually seeking their seed round, the very first investment funding round outside of the friends and family circle. When I say early-stage, I mean the typical company had 10 or fewer employees, but the founders had usually been building their business for at least a year or two. We typically sifted through several dozen (up to about 50) companies per quarter, interviewed a dozen or so by phone, and then selected 4-5 to attend our quarterly pitch event.
The prospect of getting in early on a future homerun or grand slam is attractive to some investors. For others, being involved in the investing process, negotiating the term sheet with the founders, or advising the management team are all reasons for being an angel investor. However, investors’ primary focus should be on maximizing their risk-reward, suited to their own objectives of course. I’ve learned that for me very early-stage start-ups, while they may offer the potential for 100x returns, have far lower risk-reward profiles than the companies that I now select for my portfolio. Most or all of the risks that I outlined above are present in start-ups, making the chance of a 100% investment loss fairly likely. In addition, once your investment dollars are invested they are illiquid and can’t be accessed until there is a liquidity event such as a buyout or an IPO (often 7-10 years). The high risk of a 100% loss is why angel investors and early-stage VC investors invest in a basket of companies; they understand that most of their investments will fail completely so they need many shots on goal to achieve that single homerun.
When I think of microcap companies (market capitalizations between $50M and $300M), they are a big step up from start-ups, but most still carry several risks that need to be mitigated in order for the investment thesis to work out. As I’ll get to later in this post and in future posts of this series, I look for companies that have to a large extent de-risked yet still possess other important attributes. For me and mathematically, it is much better to get a series of higher probability doubles and triples over a two- to four-year period each than a one-in-thirty chance to get a 100x over a 10-year period. The latter is likely a gross overestimation of the return that an angel investor can reasonably expect.
Biotechs hinging on a binary event
A clinical trial result that shows safety and efficacy is what clinical biotechnology companies aspire to achieve. Either that or approval by the regulator to market the therapy. The outcome of such a pivotal event is binary in that it will either send the stock into the stratosphere or into the toilet. Some investors make a living betting on biotechs and their binary outcomes. While I’m a trained molecular biologist, I possess no special knowledge or ability to forecast in advance the outcome of such binary events. It’s far easier for me to predict whether companies, which have already shown past success and dominance in their markets, will continue to excel.
No recent history of success
Companies that lack a consistent, recent track record of success are to be avoided. In my opinion, the single most reliable indicator for continued future success is the revenue growth rate as it often follows that other key performance indicators will correlate with a high rate of revenue growth and/or an acceleration in the revenue growth rate. I like to see a minimum two-year history of very high (aka hyper growth or >40%) growth. If I don’t see this in a company, then I’m rarely interested. In recent years, companies have been waiting longer to go public (IPO); this has led to high growth companies first becoming available a public investments as more mature and higher market cap companies. However, in spite of this, many still have years of high growth left in them. The IPO process gives investors at least two years of financial statements, which are usually audited by a tier-1 accounting firm.
Recently, there have been a slew companies entering the public markets through Special Purpose Acquisition Companies (SPACs). The recent success of DraftKings (DKNG), which came public via a SPAC, has raised investors’ appetite for SPACs. The eager capital, hoping for the next DKNG, poured and continues to pour into SPACs thereby further increasing interest among companies seeking to raise capital, provide liquidity for investors, and enter the public markets via SPACs. There may be some diamonds among the rough, but I’ve avoided these companies primarily because they usually lack two years of audited financial statements that I require to assess a company’s investment worthiness. I think it’s highly likely that many of these SPACs will lead to disappointing or worse returns.
So-called “story stocks” is another category of companies without a proven history of success. Story stocks are companies that have a great story of possible future success. For example, a company may have a new technology that could possibly completely transform and entire market. Investors jump aboard based on the hope and dream of riches, yet the numbers (i.e. revenue and fast revenue growth) will be necessary but do not yet back up the story. I avoid this type of hyped company and only invest when the numbers match or confirm that the story is indeed unfolding as hoped.
Foreign companies in markets without strong investor protection
The U.S. markets as well as those in most other developed nations include strong regulations designed to protect investors. Companies based in countries that lack a stable government, a strong and fair legal system, and a free democratic society are too risky for me. I once made a small profit on a Chinese fertilizer company when the firm’s insiders were allowed to buyout investors for a song. My return should have been several multiples of my investment, but instead the company’s management and early investors “stole” those gains. This experience soured me on Chinese companies, and I no longer invest in any of them. While growth in China is often great, the risk of fraud or the possibility of unilateral decisions by the authoritarian government is too great for me to risk my investment there. The U.S. and other countries with investor-friendly institutions provide ample investment opportunities.
Now that I’ve shared some of the investments that I avoid and why, I’d like to turn to how I find my growth companies.
HOW I FIND GROWTH COMPANIES
For new investors or investors who are new to investing in growth stocks, discovering a list of prospective growth stock candidates may seem daunting. Focusing first on the most important attribute (i.e. revenue growth rate), one can use a variety of sources to obtain leads. I’ll share a few that I use.
Saul’s Investing Discussions
Saul Rosenthal started a free discussion board on the Motley Fool (TMF) website. Yes, it’s completely free, and it contains a wealth of information. The board’s overarching purpose is to discuss growth stocks. Among the hundreds (perhaps thousands) of investors who follow the board are several who are quite sophisticated. New stocks are often introduced for discussion, and some veteran growth investors weigh in with their opinions. Stocks get vetted there pretty quickly with strong candidates emerging while the garbage companies are picked apart and tossed aside. Saul’s board remains my favorite source not only because many new leads can be found there but also because the opinions of some of the people who post there provide a big head start for my own analysis efforts.
The Motley Fool Newsletters
TMF has several newsletters which are available through a paid subscription. In my opinion, their best newsletter is Rule Breakers which focuses on disruptive companies, many of which are high growth. A second newsletter that can yield some leads is Stock Advisor. I most value the newsletters for their stock ideas. I don’t rely on TMF’s analysis because I prefer to analyze and assess my candidate companies for myself. One criticism of TMF newsletters has been that they are fast to recommend a buy but very slow to recommend a sell. It’s really skewed toward a buy and hold forever approach which doesn’t fit my process.
Other Investors
After sticking with investing for a while, investors tend to get to know (even if only virtually) other investors who are seeking similar types of investing opportunities. After a while it’s not too difficult to distinguish the best investors from the others. It can be rewarding to pay attention to their opinions on stocks. In addition to Saul’s board, Twitter is a popular forum where some of these investors share their ideas and opinions.
For growth investing specifically, a handful of investors have started to get quite a reputation.
Currently, the most prominent growth investor (for her recent success in 2020) is probably Cathie Wood. She runs ARK Invest with its focus on disruptive innovation. They run several funds focused in different areas such as internet and genomics. Unlike most funds, ARK publishes their trades on a daily basis. The companies that ARK buys may provide prospective growth stock candidates.
I also like to read Jamin Ball’s weekly SaaS report that he calls “Clouded Judgment”. A free email subscription is available here. I’m currently heavily invested in IT software companies so Jamin’s tracking of the various financial metrics and other key performance indicators can reveal companies that were once excluded but now merit a second look.
Upcoming IPOs
Paying attention to which private companies are preparing to file their Initial Public Offering (IPO) can provide high growth company leads. Prior to listing on a U.S. stock exchange, these companies must file an S-1 which contains the information, including a two-year history, needed for my analysis. Following the financial news, such as the CNBC network, usually will reveal which companies are nearing their IPO debut.
Stock Screens
The universe of stocks can be screened for certain metrics such as revenue growth, market cap size, profitability, and other factors. While I have not used screens extensively, they can be useful for providing leads for further investigation.
RECAP AND WHAT’S NEXT
Defining investment exclusion criteria and developing reliable lead generation sources are crucial first steps in the growth stock selection process. Once you have a short list of companies for analysis, the next step is to gather the information for the analysis. My next post in this series will focus on what, where, and how I find this information.
The opinions, thoughts, analyses, stock selections, portfolio allocations, and other content is freely shared by GauchoRico. This information should not be taken as recommendations or advice. GauchoRico does not make recommendations and does not offer financial advice. Each person/investor is responsible for making and owning their own decisions, financial and otherwise.