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Should Growth Investors Worry About Paying a Premium?

Published 02/22/2021, 04:23 AM
Updated 07/09/2023, 06:31 AM

A growth investor essentially is somebody who is willing to take a bit of risk in the short term on the expectation that the stock/ETF/other instrument will grow faster than the market.

The risk is mainly related to volatility because the price depends on future prospects rather than past performance. The past performance may not be something to write home about. The company may be reinvesting everything it makes back into the business. Or it may be making losses. Or it may be borrowing heavily.

A typical growth stock is a relatively new company, often operating in an attractive, fast-growing market. Its growth could also be coming from strong executive leadership, innovations and the ability to differentiate its products.

Technology companies like Apple AAPL, Alphabet (NASDAQ:GOOGL) GOOGL or Amazon AMZN for example generate billions of dollars in revenue. Based on their turnover, they would normally be considered mature. However, they continue to grow at a faster pace than many newer companies on the strength of their innovations, especially in new technologies like artificial intelligence that may be expected to strengthen their dominant positions.

In general however, most new companies start out growing strongly and the growth rate drops off as the base grows bigger. That’s when the company starts returning wealth to investors through dividends and share buybacks. Shares are also bought back to offset the impact of stock options, but that’s a different story.

So for the growth investor, we are looking at stocks with good stories. If that sounds like you, make sure you get a grasp on the following points-

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Keep in mind that while we don’t mind taking a risk, it had better be a calculated risk.

So first, if the company is growing its revenue but unable to grow profits, we could dig in to see just how fast its revenues are growing. Of course, a biotech company may not have any revenues at all. It may simply have a story that is dependent on the successful completion of trials and the FDA’s nod. So unless you really know what’s going on there, this could be risky for you. In general, it’s a good idea to select stocks of companies that can at least grow revenues.

Second, it doesn’t hurt if it can also grow earnings.

Third, when checking out future growth, first take a look at the fiscal year end. It could very well be that analysts expect a very attractive growth rate for the current fiscal year followed by a slowdown in the next. If the fiscal year ends in December that means you still have a few quarters of growth left to play out. But if the fiscal year ends in March, it could mean that the good period is actually over and you’re heading toward a slower period.

Take Vista Outdoor (NYSE:VSTO) VSTO for example. In the company’s fiscal year, which is to end in March, it is expected to grow revenue and earnings at a respective 22.7% and 1254.2%. But the following year, revenue growth is expected to decelerate to 4.4% and earnings are expected to decline 15.4%. So this may not be the best time to buy VSTO at a premium.

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Fourth, as I mentioned above, a growth stock often belongs to an attractive, fast-growing market. So it might help to choose stocks within attractive markets. At Zacks, we’ve seen that about half a stock’s price appreciation is related to the group that it’s in. This happens because of certain positive industrywide factors that affect all players. For example, the digitization wave that accelerated during the pandemic benefited most tech players in the semiconductor, cloud and related industries.

Fifth, it may be a good idea to check out how much fire power the company has. If it is to pursue growth, a dangerously high amount of debt could be a setback because it should have the funds to pay the interest. So it’s good if its debt cap ratio (long term debt/(long term debt + equity) is below 50%, meaning that not more than half of the funds it is using is coming from debt.

It should also be able to cover immediate liabilities. So the quick ratio ((current assets – inventory/current liabilities) should be above 1. This essentially means that its most liquid assets are more than sufficient to cover its near-term liabilities.

Now let’s consider some examples-

Century Communities (NYSE:CCS), Inc. CCS, a builder of various single-family detached and attached residential home projects in Colorado, Texas and Nevada, has a Zacks Rank #1 (Strong Buy).

It belongs to the Building Products - Home Builders industry, which is in the top 12% of Zacks-classified industries.

It is expected to grow revenue and earnings 17.8% and 33.8% in fiscal 2021, ending December. In 2022, revenue and earnings are expected to grow 10.4 and 13.5%, respectively.

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Its debt-cap ratio is 41.13% and quick ratio is 1.76X.

At 6.99X P/E, valuation is cheap.

Vishay Intertechnology (NYSE:VSH), Inc. VSH, a MOSFET semiconductor and passives supplier is based in Malvern, Pennsylvania. The shares carry a Zacks Rank #1.

The Semiconductor – Discretes industry, to which it belongs, is in the top 10% of Zacks-classified industries.

In the fiscal year ending December 2021, VSH is expected to grow revenue and earnings by 18.5% and 87.0%, respectively. The following year, revenue and earnings will grow a respective 4.7% and 9.7%.

The debt-cap ratio is 20.01% and the quick ratio is 2.22X.

Its forward P/E of 13.74X means valuation is attractive.

Zacks #1 ranked Cohu, Inc. (NASDAQ:COHU) makes semiconductor test and inspection handlers, micro-electro mechanical system (MEMS) test modules, test contactors and thermal sub-systems used by global semiconductor manufacturers and test subcontractors.

The Electronics - Manufacturing Machinery industry to which it belongs is in the top 5% of Zacks-classified industries.

The company is expected to grow revenue and earnings a respective 34.0% and 163.0% this year followed by a respective 5.4% and 10.8% in the next.

The debt-cap ratio is 37.85% and the quick ratio is 1.96X.

Its forward P/E of 14.90X makes valuation attractive.

PPG Industries (NYSE:PPG), Inc. PPG is a global supplier of paints, coatings, chemicals, specialty materials, glass, and fiber glass. The shares carry a Zacks Rank #2 (Buy).

The Chemical - Diversified industry to which it belongs is in the top 18% of Zacks-classified industries.

Its revenue and earnings are expected to grow a respective 16.2% and 32.3% this year followed by a respective 5.6% and 12.0% in the next.

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The debt-cap ratio is 47.09% and the quick ratio is 1.05X.

Its forward P/E of 18.12X makes valuation attractive

Winnebago Industries (NYSE:WGO), Inc. WGO has been producing recreational vehicles (RV) in the United States for 60+ years.

It belongs in the Building Products - Mobile Homes and RV Builders industry (top 2%).

Revenue growth in the current fiscal year to end in August is 36.6% while earnings growth is 129.5%. The following year, revenue is expected to grow 3.1% and earnings 4.4%.

The debt-cap ratio is 37.21% and the quick ratio is 1.77X.

Its forward P/E of 12.11X makes valuation attractive.


It’s alright to pay a premium for a growth stock, but the goal should be to minimize risk. Because even a hot stock could be a dud as far as you’re concerned and what appears to be boring, could end up being just what you were looking for. So just because you’re thinking growth doesn’t mean you have to take a lot of losses. In fact, if you want to win in the long term, take loss minimization seriously.

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