Eight growth stocks that make the grade

Growth strategies have struggled recently, but Stockopedia's Ben Hobson names those which pass the test.

Stock market cycles dictate that there are times when certain styles of investing will seriously struggle for buying ideas. In bull markets, when prices are rising, value strategies dry up. In bear markets, when fast-moving stocks can be pulverised, momentum strategies suffer badly. 

Then there are growth strategies, which are just as sensitive to changes in market trends. Since the middle of 2018, we've see a sharp fall in the number of stocks making the grade as genuine growth company investments. But why?

Part of the answer is down to the way many growth stock strategies work. There are some big differences in the precise details of some of the best-known strategies, but most use a handful of key concepts. First, they look for company earnings to be growing. Second, the stocks shouldn’t be too expensive. And third, there should be at least some positive momentum in the stock. 

Let's look at these factors in more depth…

Fast and persistent earnings growth

I don't think you'll find a regular growth strategy that doesn't take some kind of lead from a company's earnings. Historic profitability and the expectation that earnings will keep growing is usually crucial. 

If you're a fan of the US traders Mark Minervini or William O'Neil, for example, you'll be looking for quarter-on-quarter acceleration in earnings growth. If Robbie Burns, the Naked Trader, or perhaps Jim Slater is more your style, then earnings growth should at least be positive over the past year. Meanwhile, others, who take a longer-term view of "growth at a reasonable price" (GARP) might look for five- or even 10-year positive earnings growth rates. 

Growth at what price?

The importance of price is what divides growth investors into two camps. In one, GARP specialists like Robbie Burns wouldn't overpay for a share. A price/earnings (PE) ratio of 20 is generally the ceiling in these kinds of strategies. That would definitely have priced you out of some of the best performing growth stocks in recent years, for good or bad.

Other types of GARP investor, like Jim Slater and Peter Lynch, focused on the relationship between price and growth. They both used interpretations of the price to earnings growth rate (or PEG) as a guide to whether a growth stocks was reasonably priced. A PEG of less than 1 indicates that a company is growing EPS faster than its price-to-earnings ratio, and can be a pointer to cheap growth stocks.

But investors like Minervini, O'Neil and Charles Kirkpatrick are less concerned about price. They take more of a technical approach to fast-moving stocks, profiting from sharp upward moves but ready to bail out on any weakness. 

Positive price trend

One of the common features of many growth strategies is they tend to avoid falling share prices.  For traders like Bill O'Neil and Minervini, price trend is important regardless of value, so they look for stocks breaking out from recent trends. 

But GARP strategies take price momentum seriously too. Peter Lynch was well known for his desire to find 'tenbaggers' - the stocks that could literally make him ten times his original investment. But to do that, they had to be breaking new price highs. It was a classic example of why relative strength against the market is so important for growth investors. The same goes for other GARP strategies, including Jim Slater's.

Screening for growth 

Crucially, it seems that the negative momentum that swept through the market last year has caused growth strategies to run short of ideas in the current conditions. Many growth stocks fell hard when the market tumbled in 2018, and that negative 1-year momentum means they aren't yet passing all the rules that growth investors tend to set. If markets remain settled, that will likely change.

But while market conditions have put pressure on the price trends of many growth stocks, not all of them have suffered. Here are some of the stocks currently passing the "growth at any price" tests of a screen modelled on the approach of Bill O'Neil.

Source: Stockopedia Past performance is not a guide to future performance

This is a trader's approach to stock screening because it goes looking for new trends and breakouts - both in earnings and price. That's exactly what we've seen from stocks like Softcat (LSE:SCT), Kingspan (LSE:KGP), Spectra Systems (LSE:SPSY) and Morgan Sindall (LSE:MGNS) in recent months. But it's important to remember with this approach that any stock-specific uncertainty could send prices tumbling. O'Neil's strategy was always to sell stocks on the early signs of weakness.

Over the past eight months, negative momentum in the market has meant that many growth stocks have failed to pass the rules for some of the classic strategies. As they start to claw their way back and build up momentum, it's likely that we'll see them return to some of these screens. So, for now, growth isn't dead, it just needs to build some momentum again.

About Stockopedia

Stockopedia helps individual investors beat the stockmarket by providing stock rankings, screening tools, portfolio analytics and premium editorial. The service takes an evidence-based approach to investing, and uses the principles of factor investing and behavioural finance to help investors make better decisions.

Interactive Investor readers can get a free 14-day trial of Stockopedia by clicking here.

These investment articles are simply for generating ideas. If you are thinking of investing they should only ever be a starting point for your own in-depth research.