These are the stocks you should think about keeping, even if the broader market craters
Peter Hodson looks at five indicators that may guide you in making a wise decision.
It's time to get back to basics. As the market continues to run, we think it is wise for investors to take a look at their growth stocks to make sure they remain comfortable with their holdings at ever-increasing valuations.
Some stocks are very expensive but worth it. Conversely, some companies are very expensive and destined for a sharp fall if the market breaks. How do you know the difference?
Let's look at five financial indicators that may at least help in one's decision. We also highlight some stocks for each of the five criteria.
1) Return on equity (ROE)
Some investors believe this is the single most important financial ratio, and some hedge funds are run entirely on that principle. We do see it as very important, but we don't think any ratio should be looked at in isolation. ROE, essentially, tells investors what the company's return has been on the total amount of capital invested or retained within the company. A figure above 20 per cent is generally considered very good. Companies such as Qualcomm, Pool Corp., Crocs, Medifast and Constellation Software
all screened very well on a high three-year average return on equity (all averaging more than 40 per cent in a Bloomberg data screen). High ROE typically — but not always — results in strong stock returns.
2) The rule of 40
The Rule of 40 is a common metric used by equity investors and strategic stock buyers to measure the performance of software companies but it can be applied to other sectors as well. Measuring the trade-off between profitability and growth, the Rule of 40 asserts that a successful company's growth rate and profit margin should add up to 40 per cent or more. Essentially, it means if one can find a company with very rapid growth and high margins, an investor might be on to a potential winner. Companies hitting this rule threshold recently include: Adobe, VM Ware, Veeva Systems, Salesforce and Docusign.
3) Sales growth
We are big believers in growth, and if a company cannot at least increase its top-line sales numbers, then we are not really interested in it. Essentially, it is the data point we always start with, as growth investors. We are not interested so much in flat sales, or cyclical growth where there is high variability. We want high — and consistent — growth. This is one of the easier metrics to look for in companies. Bloomberg shows more than 300 companies with a compound annual growth rate of sales of more than 40 per cent over the past five years, with a market capitalization of $3 billion or more. Some notables: Carvana, Canopy Growth, Invitae, Snap Inc. and Shopify.
4) Debt ratios
We don't mind a little bit of debt, but too much can hurt a stock a lot, even kill a company. It is hard enough to pick good stocks, so having a strong balance sheet at least means investors do not have to worry about the survivability of a company in a downturn. Everything is fine now, but in a recession balance sheet strength becomes significantly more important. Some companies with very strong balance sheets, including tons of cash, right now include: Apple, Alphabet, Shopify, Kinaxis, Winpak, Spin Master and Parex.
5) Positive momentum
We have discussed this before but as a reminder, remember you as an investor will never make any money unless others believe in your stock as well. This is where momentum factors such as positive earnings surprises, new highs, analyst target revisions and earnings acceleration come into play. Some stocks currently showing strong momentum are: Premium Brands Holdings, Aritzia, ECN Capital, Nuvei Corp. and CI Financial. We think if you can find some stocks that have all of these criteria, you may be on to a good investment. You have strong growth, strong return on equity, a solid balance sheet, little or no financial risk, and strong stock momentum. If you get a stock having all of these characteristics, we would not want to sell too early.
Peter Hodson, CFA, is founder and head of Research at 5i Research Inc., an independent investment research network helping do-it-yourself investors reach their investment goals. He is also associate portfolio manager for the i2i Long/short U.S. Equity Fund. (5i Research staff do not own Canadian stocks. i2i Long/short Fund may own non-canadian stocks mentioned).