Has picking the right stocks ever been more important? Earnings shortfalls, rising defaults, excess capacity--you've heard the bad news. As markets everywhere tumble, the importance of smart stockpicking increases exponentially. Only the strongest companies will continue to rise. These aren't your flavor-of-the-month stocks, but those with excellent management, sound business plans, solid financials, and great prospects.
How do you find such companies? The BusinessWeek 50 offers one approach. It's a rigorous screening of the companies in the Standard & Poor's 500-stock index with the best revenue growth, earnings growth, profitability, and stock market performance. But there are worthy companies that are not listed in the S&P 500. And some are just too obscure or too small. You'll find some of those up-and-comers in the S&P MidCap 400 and the S&P SmallCap 600.
We've outlined 12 key criteria investors need to consider when looking for companies with great growth prospects. Some measures, such as revenues, earnings, and profitability are objective. You can find those numbers in company reports, compare them with other companies', and make decisions based on them. We have tools to help crunch the numbers at our Web site (www.businessweek.com/bw50/). Other criteria are subjective--sizing up a company's competitive edge or the quality of its management.
Bear in mind that it's likely that no single company will clear all 12 hurdles. In assembling a portfolio, you look for companies that pass several of the tests--and not all the same ones. Some will be strong on revenue and earnings growth, others may have excellent returns on capital, or healthy cash flows. The point is that your portfolio touches as many bases as possible.
1. REVENUE GROWTH
One of the defining attributes of growth companies is an acceleration of revenues. After all, rising revenues often correlate well with rising stock prices (chart). For instance, from the end of 1997 through 2000, sales at Calpine Corp. (CPN
), an electricity outfit ranked third in the BW 50, grew from $276 million to $2.3 billion. During the same period, the stock jumped to more than $45 from around $2.
Strong sales growth indicates that a company has a superior product that's in demand. The desired amount of growth depends on the size of the company. Small companies, with market capitalizations of less than $2 billion, are riskier because they may be highly dependent on one or two products or a key executive. For those companies, your hurdle rate should be high: 20% to 25% a year for the next several years. For larger companies, 15% revenue growth is a good minimum.
A cautionary note: Your investigation of top-line growth doesn't end at the top line. What's key is that the company is growing by increasing sales--and not by buying growth through acquisitions. ``Growing through acquisitions doesn't tell us much,'' says manager Jim Oberweis of Oberweis Emerging Growth Fund. ``It doesn't show me people like the company's products.'' Sure, there are exceptions. The BW 50's No. 1 company, Tyco International Ltd. (TYC
), has thrived by snapping up electronics and medical equipment companies. But many acquisition strategies crumble over time.
2. EARNINGS GROWTH
Sales without profits are meaningless. Eventually--better sooner than later--a company with good sales growth must turn a profit. The dot-coms got away with profitless growth until investors wised up and drove their prices into the ground.
The best source of earnings growth comes from sales growth. If revenue growth is, say, 30% a year, earnings should be about that much. But for newly profitable companies, earnings growth can be huge: A company that goes from earning 2 cents a share to 4 cents has a 100% gain. As a company earns more substantial profits, the rate will generally fall in line with the rate of revenue growth.
Beware: Companies can get earnings growth other ways. Many boost their earnings per share by buying back stock--doing nothing to increase net income. Investors need to examine financial statements to learn if an earnings boost comes from accounting changes, tax refunds, or asset sales--none of which reflects whether the company is generating profits.
3. RETURN ON CAPITAL
A company might be posting some strong profit growth, but that's only in comparison to what it made last quarter or last year. How do you determine whether a company is making money relative to the capital invested in it?
Figuring Return on Capital
SEI Investments
NET INCOME (2000)
$98.96 Million
DEBT + EQUITY (2000)
$169.50 Million
RETURN ON CAPITAL
98.96/169.50 = 58.3
Data: Bloomberg Financial Markets
The calculation is easy. Return on capital is net income divided by total capital, which is debt plus equity. The standard varies by industry. Look at SEI Investments Co. (SEIC
), which is both a money manager and a provider of back-office services to other financial institutions. Net income in 2000 was $99 million, and capital, $169.5 million. That's a 58% return on capital, which is extraordinarily high, even considering that service businesses operate on less capital than, say, manufacturers. The ROC for the S&P 500 is less than 10%. Growth investors should expect more: a minimum of 15%.
What if a company has high earnings growth but a low return on capital? That indicates it may be using debt to amplify growth. If it is overleveraged, a company will take a hit during a credit crunch or a recession. Feminine hygiene company Playtex Products Inc. (PYX
) suffers from this problem. Though it has rapid earnings growth, its return on capital is low because of $1.2 billion in debt. When the interest rates on its debt rose last year, it had to lower its earnings projections. Companies with high returns on capital don't need outside financing to grow.
4. CASH FLOW
Cash flow is a term finance types toss around rather casually. And it's defined in different ways. The simplest approach is this: Determine what the company is earning before the accountants deduct depreciation and amortization, intangible costs that have no impact on the company's underlying profitability.
Analysts often use cash flow as a litmus test for earnings quality. If earnings are much higher or lower than cash flow, then the stated earnings may be unreliable. Compare BW 50 members Sun Microsystems Inc. (SUNW
) and Oracle Corp. (ORCL
) In fiscal 2000, Sun had $1.9 billion in earnings and twice that in cash flow. Sun's earnings are understated. Oracle, on the other hand, has $1.1 billion in profits so far in fiscal 2001, but only $266 million in operating cash flow. The company booked a capital-gains tax payment in fiscal 2000, but didn't pay it until 2001. So Oracle's 2001 earnings are overstated.
5. MANAGEMENT
Great management may be the most difficult thing to quantify. Yet it is critical for fast-growing companies in rapidly changing industries. An experienced leader, with a clear vision of how the outfit will make its mark, must be at the helm. The best managers
Look for Insider Ownership
Juniper Networks
CEO
SCOTT KRIENS
TOTAL COMPENSATION, 2000
$175,000
UNEXERCISED OPTIONS
$900,000
NUMBER OF SHARES OWNED
18,280,794
CURRENT VALUE
$1.0 BILLION
INSIDERS (INCLUDING KRIENS) OWN
33%
Data: Bloomberg Financial Markets, Morningstar
always have a personal stake in their company's success. For a growth company, the CEO should own at least 5% of the company's stock, and insiders--the CEO plus high-ranking executives and board members--at least 30%. At Juniper Networks Inc. (JNPR
), for instance, CEO Scott Kriens owns 18.3 million shares, or 5.8% of the company. Insiders own 33%.
At large companies, the top brass should also have most of their personal wealth invested in the company, but precise percentages are less important. Nick Calamos of Calamos Growth Fund prefers companies where executive compensation is ``tied to the objectives of the business, not to the price of the stock.'' He argues that bonuses should be based on sales and earnings targets. That ensures the manager isn't there just to pump the stock up and leave. Insider ownership and compensation data can be found in Securities & Exchange Commission filings at www.edgar-online.com and Yahoo! Finance at finance.yahoo.com.
6. PRICE-EARNINGS RATIOS
The price-to-earnings ratio is the most popular valuation metric--the stock's price divided by the earnings per share. Many people plug in the last 12 months' earnings for the ''e,'' since it is a known number. But investing in stocks is all about the future, so a more useful p-e measure incorporates some estimate of the next 12 months' earnings.
Compare P-E to Growth Rate
ADC Telecommunications
PRICE
$11.38
EARNINGS PER SHARE*
$0.59
PRICE-EARNINGS RATIO
19.3
ANNUAL EARNINGS GROWTH**
27.2
P-E RATIO/EARNINGS GROWTH RATE
0.7
* 2001 est.
** 5-yr est.
Data: Morningstar, Zacks Investment Research
P-E's vary by industry, so it is hard to come up with one number as a good benchmark. Some investors take the p-E a step further, and compare it with the estimated five-year earnings growth rate. This is called the PEG ratio, for price-earnings to growth. The lower the PEG, the better. For instance, ADC Telecommunications (ADCT
) has a 19.3 forward p-e, and estimated long-term earnings growth of 27.2%, so its PEG is 0.7. Relative to its expected growth rate, it's 30% undervalued. Citigroup Inc. (C
), on the other hand, has a lower forward P-E, 16.5, but lower growth estimates, 14.4%. Its 1.1 PEG indicates it's 10% overvalued.
Yet PEG ratios are only as accurate as analysts' earnings estimates. If estimates come down, a stock with a low PEG doesn't look cheap anymore. That's why smart investors give themselves a margin of error. For small and midsize companies, the PEG ratio should be well below 1. But for large companies with more established product lines, buying a stock at a price that's one times the growth rate is fine. Most growth managers also look at a stock's p-e relative to its industry peers and its own historical valuation to judge whether the company is a bargain.
7. OTHER VALUATION TOOLS
Besides p-e, investors need to look at the p-s and p-b ratios. The p-s, or price-to-sales ratio, is a stock's price divided by its revenues per share. Since sales are harder to manipulate than earnings, this stat provides a reality check for a suspiciously low p-e. The same can be said for the price-to-book-value ratio. The p-b is a stock's price divided by its book value per share. Book value is the value of a company's assets--such as factory and equipment--if they were liquidated.
Compare Stock with Peers
STOCK
WAL-MART
MICROSOFT
PRICE-SALES RATIO
1.1
12.0
INDUSTRY
RETAIL
SOFTWARE
PRICE-SALES RATIO
1.1
12.1
Data: Morningstar
For both ratios, you should apply a relative valuation approach. Look at a company's ratios relative to its history and its peers, rather than setting absolute benchmarks. For instance, since retail companies have lower profit margins than software makers, their sales aren't as valuable. So comparing the 1.1 price-to-sales ratio of Wal-Mart Stores Inc. (WMT
) with Microsoft Corp.'s (MSFT
) 12.0 p-s makes no sense. Better to compare Wal-Mart with Target (TGT
) or Kohl's (KSS
). Looking for stocks that are cheap relative to their five-year average price-to-sales ratio has worked well in the 1990s. ``It was one of the most effective measures,'' says editor Richard Moroney of the newsletter Dow Theory Forecast.
8. EARNINGS VISIBILITY
How sure are you of the growth projections of your favorite stock? Companies that grow consistently, regardless of economic conditions, deserve higher valuations. The key is to look for stocks benefiting from favorable long-term trends. The outlook for pharmaceutical companies like Merck (MRK
), for instance, is bright because of the aging of the baby boomers, which is going to happen regardless of the quarterly changes in gross domestic product. Moreover, many drugs are necessities so their sales are always brisk. ``If the economy gets lousy, you might hold off on that suit or pair of shoes, but you can't reduce the drugs you buy,'' says portfolio manager Jon Burnham of the Burnham Fund.
What about technology? The last few months have reminded us that tech stocks are far more cyclical--sensitive to the ups and downs of the economy--than investors previously thought. Personal computer and semiconductor makers Compaq Computer Corp. (CPQ
) and Intel Corp. (INTC
) are seeing their sales decline during the economic slowdown. Although still growth companies, their stocks are best purchased at the trough of an economic slowdown, not at the end of a growth spurt. Timing, with cyclical stocks, is everything.
9. COMPETITION
The best growth companies are the top players in their industries. Either that or they're winning market share from the top players. This takes some research, but much of it is just common sense. Look for companies with proprietary databases, distribution networks, or exceptionally high levels of customer service, all of which are hard for competitors to duplicate. Drug companies can do well in the competition cut, because their patents afford some protection for high-margin drugs. Technology companies are more vulnerable. Sure, there are patents, but newer technologies often sweep in to make them obsolete.
Market share is also an important attribute. The biggest players always have more control over the pricing of their products. Second-tier competitors end up having their prices set by the leaders, an unfavorable position to be in.
10. ACCOUNTING
Accounting practices should be conservative, and that's often hard to find at a fast-growing outfit. The pressure to show strong revenues and profits leads companies into aggressive bookkeeping. When Cisco Systems Inc.'s (CSCO
) customers couldn't come up with the money to buy its products, Cisco extended them credit. That can work for a while. But when customers couldn't pay, Cisco ended up setting aside $350 million for bad debts.
Investors can protect themselves somewhat against such surprises. Look at a company's cash-flow statement to see if receivables--goods and services the company has sold, but not received payment for--are rising. If they are, the company may be lending customers money to keep up sales. If the borrowers default or go bankrupt, the debt may never be repaid.
11. MOMENTUM
Growth stocks that meet expectations have strong upward momentum. If a company's earnings prospects are truly great, it should perform better than the stock market and its industry peers. But if the market is moving up, and your growth stock is lagging behind, it could be a sign of trouble. ``If we see a stock not performing well, it's a yellow flag that we should intensify our research,'' says manager Foster Friess of Brandywine Fund. ``It could be a tipoff to changing fundamentals.'' Unless you're certain that the growth prospects are intact, you should avoid companies that have trailed the market for more than one quarter.
12. DEBT
Debt can kill a growth company if its sales slow so much that it can't make interest payments. ``The more debt, the more risk,'' Oberweis says. ``But if you've got a company with great earnings growth, more debt is an advantage. You profit from the leverage.''
How much is too much? First look at the capital, which is debt and equity. As a rule of thumb, the debt should be less than 50%. But it's best to compare companies in the same industry. For industries where revenues swing wildly--say, retailing or semiconductors--the less debt the better. Industries with stable revenues can handle more debt. Old-fashioned utilities--water, gas, telecom, electric--often fall into this category. However, as last year's telecom flameout proved, even they can fall victim to overleverage. Any company borrowing beyond its means is flirting with disaster.
Copyright 2001 , by The McGraw-Hill Companies Inc. All rights reserved.
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Strong sales growth indicates that a company has a superior product that's in demand. The desired amount of growth depends on the size of the company. Small companies, with market capitalizations of less than $2 billion, are riskier because they may be highly dependent on one or two products or a key executive. For those companies, your hurdle rate should be high: 20% to 25% a year for the next several years. For larger companies, 15% revenue growth is a good minimum.