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Lessons for Investors

A strategy of investing in high growth companies, based solely upon past earnings growth or analyst projections of growth, can be dangerous for several reasons. You will need to screen this portfolio to make sure that you are not overpaying for the growth, that the growth can be sustained, that the risk exposure is not excessive and that it is high-quality growth. To accomplish these objectives, we screened the universe of U.S. companies with the following criteria:

  • Growth screens: Only companies with projected earnings growth greater than 15% over the next five years were considered for the portfolio. This does eliminate smaller firms that are not followed by analysts, but expected future growth is too critical an input for this strategy to be based solely on past earnings growth.

  • Pricing screens: Only companies with PE ratios less than the expected earnings growth (PEG less than 1) were considered for this portfolio. While this is not as strict a screen as the one used earlier in this chapter, it conforms to a widely used standard for pricing (i.e., that stocks trading at PE ratios less than expected growth rates are underpriced).

  • Sustainability of growth: While there is no simple test for sustainability, the evidence seems to indicate that companies with high revenue growth in the past are more likely to sustain this growth in the future. Consequently, only firms with revenue growth of more than 10% a year over the last five years were considered.

  • Risk exposure: To keep the risk in the portfolio under reasonable bounds, only firms with betas less than 1.25 and standard deviations in stock prices less than 80% were considered for the analysis.

  • High-quality growth: Only firms with returns on equity that exceeded 15% in the most recent financial year were considered for the final portfolio. This is stricter than the standard used in the last section, but high-quality growth is an important factor in the ultimate success of this strategy.


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