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3 steps to pick winning growth shares

I wonder how many of you are familiar with the ‘amoeba theory of growth investing’. Anyone?

I’ll hazard a guess and say not many because it is an idea I came up with while playing around with my calculator. So without further ado, here it is.

Q: If an amoeba in a jar doubled every second, and it took precisely one minute for the amoebas to fill the jar, how long would it take for the jar to be exactly half full?

(Hint 1: Forget about the size of the jar and the size of the amoeba)

(Hint 2: The answer is not 30 seconds)

The correct answer is of course 59 seconds, because one second after that — at precisely one minute — the amoebas will have doubled and the jar would become full.

Still with me? Excellent!

But what does this have to do with growth investing? As it turns out, quite a bit. Allow me to explain.

The good old growth days

Growth investing is all about buying companies that can expand much faster than the wider economy.

If you are as old as me, you’ll remember that growth shares last became very popular during the 90s. In particular, companies associated with technology, media and telecoms were all the rage back then. Growth investors were making money hand over fist — often effortlessly.

Unfortunately, many growth investors hit big trouble after the tech boom peaked during early 2000. You see, the bursting of the dotcom bubble was a bit like my jar of amoebas after 59 seconds.

All those TMTs had seen long-time rapid earnings growth but suddenly, the amazing profit growth within the sector came to a stop and some racy P/Es were left extremely exposed. For tech investors at least, the amoeba jar had become completely full!

The combination of falling earnings and a de-rated P/E spelled disastrous returns for growth investors.

So how can you profit from growth companies?

I must admit, I took my knocks during the dotcom bust.

However, my experience in the tech crash — as well as observing the varying fortunes of growth companies before and since — have helped me devise these three crucial steps for sorting the growth-share wheat from the also-ran chaff.

1. A good track record… in good times and bad

Companies with records of rising profits are obvious contenders for a growth-share portfolio. But it’s important to consider the business environment when the great track record was established. You see, the record may have been buoyed by favourable events (e.g. the advent of the Internet in the 90s), and the business might actually crumble in a downturn.

Thankfully we don’t have this problem right now — as any firm that’s recorded consistent growth in the last few recessionary years must surely possess special growth qualities! But as and when the economy improves, the chances of being tricked by a growth-share imposter will increase.

2. Know your (market’s) limits

Many of the very best growth shares operate in sectors with tailwinds behind them, which should allow profits to extend further as the sector expands. Trouble is, tailwinds so often become headwinds — and you end up with a full jar of amoebas!

I’ve seen many mini-growth sectors come and go in my time, but an area particularly prone to growth-share disappointment is the ‘consumer rollout’. Shops, gyms, restaurants or similar — all can be rolled out across the country to generate super earnings growth. But with a relatively small and concentrated population, there are only so many towns and cities to cover before saturation hits… and the amoebas fill the jar.

3. Pay a fair price for growth

Paying the right price for growth can be very difficult, as I’ve seen excited investors extrapolate rapid earnings growth well into the future to justify extreme valuations. Sometimes no price can be too high!

But as late-90s tech investors know, pay too rich a P/E and your losses will be heavy if your projections are too optimistic. So you have to weigh up the rate of further earnings growth, the risk of things going wrong, and what the P/E is already expecting. In fact, I’ve found backing mid-range growers on mid-range multiples can frequently offer more reliability than going for full-on growers on tip-top P/Es.

Foolish bottom line

I hope that’s given you a sense of how to separate the champs from the chumps. Growth is important – almost imperative unless you’re aiming for a liquidation or the yield is sky high (and sustainable) – but misunderstanding the opportunity can be disastrous.

The ASX is already on the move in 2012, and Goldman Sachs experts recently said they reckon S&P/ASX 200 could top 5,000 next year. Read This Before The Coming Market Rally is a must-read for investors who don’t want to miss out on the party. Click here now to request your free copy, before it’s too late.

Take Stock is The Motley Fool Australia’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it’s still available. This article contains general investment advice only (under AFSL 400691).

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