How to find growth in barren markets

Despite the economic gloom, it may be time to give growth stocks another try, says Tim Bennett. Here, he explains how to pick the winners from the losers.

In today's troubled global economy, it's tempting to invest as defensively as you can. Sometimes it seems that practically every other fund manager in the market has given up worrying about capital growth in favour of recommending high-quality', if dull, blue-chip stocks that can pay a modest income in the form of a reliable dividend yield.

That's fine. We still like defensives and see nothing wrong with holding on to your dividend-payers. With Europe constantly on the verge of collapse, China looking wobbly, and Britain back in recession, there's plenty of scope for further scares in global markets. But you shouldn't ignore growth' stocks completely you just need to ensure you buy at the right time. And now could be one of those times.

The fact is that some stocks can deliver growth even when the macro-economic backdrop is appalling. As Morgan Stanley's Ronan Carr notes, in the 1960s and 1970s, a 'nifty fifty' band of growth stocks outperformed the key US index, the S&P 500, by 15% a year for a period of eight years. The wider market essentially went nowhere over the same timeframe.

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Better still, these stocks delivered even during the worst bear market of that time. So reliable were these stocks that they became known as "one-decision stocks" once bought, they were never to be sold.

Of course, as any contrarian worth their salt knows, when you hear stocks or any other asset described in such loving terms, it means investors are getting carried away. So it proved. The big crash for the nifty fifty came in the mid-1970s, but not before prices had been driven up to the point where these companies were trading on a collective average price/earnings (p/e) ratio of 45 times and an average price-to-book of over eight times.

The next lesson for investors on when not to buy growth stocks came 20 years later. The technology boom of the late 1990s saw wild projections abound about the future growth rates and eventual size of the market. Investors, excited about the potential of the internet, piled into firms on the strength of growing sales alone, or even just potential sales measured as 'eyeballs' or 'clicks' on a page. Unbridled euphoria drove p/e ratios on the Nasdaq, the US technology index, past 50, then 100, then beyond. A huge bubble formed, which destroyed many investors' portfolios when it popped.

So what can today's growth stock pickers learn from the mayhem of the 1970s and the 1990s? Here are four lessons to heed.

Growth must be consistent

Flash-in-the-pan growth is bound to end in tears unless you get your timing spot on in terms of buying and selling a stock. So the first characteristic of a decent growth stock is a solid track record of growth. Sales are not enough anyone can sell £10 notes for £9 and achieve sales. You need to see consistent earnings per share (EPS) growth.

Morgan Stanley's Carr looks for a track record of earnings growth over the last five to ten years, based on "the average quarterly change in earnings forecasts, the volatility of those estimate changes and the consistency with which earnings changes are positive".

Projections must be realistic

People and companies often make daft predictions, mainly by extrapolating an existing trend into the far future. For example, when I was job hunting in the late 1980s, one large accountancy firm's forecasts of their graduate recruitment growth suggested that within ten years they would be employing the entire graduate output of Britain.

That clearly wasn't going to happen, and indeed it didn't. To take another example, a few US banks have recently suggested they will grow annual earnings by anywhere between 15%-20% compound. Again, this is unrealistic at that rate they'd pretty soon outgrow the entire market.

So a company needs to have room to grow. One thing to look for is signs of market saturation. In Britain, for example, the Competition Commission can stop a firm from taking over another when its size makes it anti-competitive. At that point overseas growth is usually the next target. But this can be much harder to achieve, as retailing giants Tesco and Marks & Spencer both discovered after some ill-fated forays into the US market.

Only pay a fair price for growth

As the Motley Fool's David Kuo points out, there's a right price for everything, and that includes growth stocks. Investors in the nifty fifty' and the dotcom bubble learned the hard way that you mustn't overpay for growth. The good news for today's growth-seekers is that many other investors are fixated on safety, so some growth stocks trade on compelling valuation multiples.

I'd suggest two tests as a minimum. Kuo steers clear of anything with "too rich a p/e ratio". One way to test this is via the price-to-earnings-growth (PEG) ratio. It compares the p/e ratio to the expected rate of earnings per share growth. The ideal is something below, or not far from one. A high multiple is a red flag that growth is being overpriced.

Don't buy a weakling

Carr points out that in a tough patch for the global economy, even growth stocks need to have defensive characteristics. A quick test that they are generating consistent cash flow is a dividend yield of, ideally, 3% or above, consistent dividend growth, and a low payout ratio (the proportion of annual earnings paid out as a dividend).

A final, good test for balance sheet strength is a Piotroski score of seven or higher. This looks at nine measures of financial strength with firms scoring one point per test passed.

Using Carr's screen, the top-scoring sectors are automobiles, materials and energy. Of these, we'd favour oil giant Shell (LSE: RDSB), as it is less exposed to a slowdown in China than the automobile or material industries.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.