Analyzing Growth Stock (Part 2)

Objective

• Definition of growth stock
• The framework of growth stock analysis
• How to identify a first grade growth stock (with example)
• Risks & rewards of growth stock (with example)

Forget everything about value investing, not applicable here.

Introduction

There are 2 type of growth stocks, according to "Picking growth stock" by T. Rowe Price Jr.

• First Grade growth stocks= Market Leader, Established and with strong financial
• Second Grade growth stock = Unseasoned, depend on few product/patent, weak financial.

It is extremely risky to invest in second grade growth stocks as there are high chance of failure rate for new start up. Personally, i don't invest in those unprofitable and unestablished buisness, because is too risky.

While some will argue that if you invested in Amazon during its IPO, you will already 3000x your money. However, this idea is highly not probable because:

• You have to be lucky to pick one winners out of hundred of losers
• And when all the dot com stock go bust one by one, and Amazon drop 95% will you still hold?

Same for Tesla, do you know it almost go bankrupt in 2018, if Elon did not get any funding?

Definition of growth Stocks

A growth stock is any shares in a company anticipated to growth at an significant rate above the market. The stock price is always correlated to earnings. If the earnings growth rate increases, the stock price will follows and vice versa (see link below if want to read more). It is all about how fast the business can increase it earnings and market expectation when come to growth stocks.

https://seedly.sg/opinions/what-to-focus-on-when-invest-in-buisnesses

The Framework of growth stock analysis

For this framework, we going to hunt for first grade growth stocks, profitable and compounding growth stock. We going to look at revenue, earnings and market expectation.

How to identify First grade growth stock?

Step 1. The most important of a first grade growth stocks are that they have a strong financial statement. For example, i will use KLA Corporation (KLAC). Some of the key item we should look at, but not limited to, are as follow:

• Increasing revenue
• Decreasing outstanding shares (help to increase EPS)
• profit margin (double digit)
• Increasing free cashflow

Step 2. Trends

When investing in growth stocks, as earnings get higher and higher, the market will valuate (P/E) higher and higher. The increasing in earnings and the expansion of the P/E as investors get more and more optimistic will result in higher stock price. Assuming the revenue will 2x for the next 5 years (15% p.a.) for KLAC.

Risks & Rewards

Case 1- the objective is to see if the stock price is following the earnings line or following the PE line. It is highly unlikely for the PE to fall to 6 (too low). Thus the stock price is following the earning line. Which is good for growth stocks

Case 2- the objective is to see how much growth rate had factor into current stock price. Meaning if KLAC growth at a 4%p.a. rate. The stock price may remain stagnent. Below it, the stock price may decline

Case 3- the objective is to see what is the most optimistic stock price it will reach after 5 years.

Conclusions

The key of investing growth stock is not so much about the buisness, is more about valuation and stock price. Amazon did very well for the past 20 years but take more than 10 years from the dot com bubble to meet market expectation and go into another growth cycle. This is what make growth stock riskier, thus higher reward.

When invest in growth stocks, it is important to ask yourself what is the probability of KLAC grow at 20%, 15% , 10% or lower. What is the growth that already factor into the price.

To summarise, if today the growth meet expectation, stock price will likely grow at the same rate. if today, you can find a stock that can beat expectation, that not yet discover, you will have a winner. Higher expectation lead to higher stock price, lead to more hype, lead to higher price, cycle continue until it fail to deliver. What you want to avoid is growth that has lower than market expectation. (Refer to the framework chart). These explain why most growth go into consolidation most of time and very volatile, and explode during good news and earnings.