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Do you know the 3 kinds of growth stocks?

In the book One Up on Wall Street by former fund manager Peter Lynch, the author wrote about the importance of understanding a stock’s earnings growth potential. He was famous for his successful investing performance in the U.S. at Fidelity Investments in the 1980s.

Of the six categories he regularly used for describing stocks, three of them were to distinguish what kind of a grower a company was. Investors need to make that distinction when choosing to buy and even hold onto stocks because their nature will influence your overall rate of return.

After working out a company’s place and standing in its industry, what growth can you expect to achieve?

Category 1: slow growers

Aging and large companies that at one time were market darlings and fast growers, now plod along with the general growth of the economy. Right now, the Australian economy is growing on an annualised basis of about 2% – 3%, but over the long-term the economy has grown at faster rates, so a slow grower in this respect might be achieving 5% – 8% earnings growth consistently.

Although not bad, you can’t expect them to rapidly rise in price unless there has been a heavy bear market like the GFC to recover from.

Telstra (ASX: TLS) is the largest telecommunications company in Australia, with a market capitalisation at $61.8 billion. Over the last two or three years, the share price has been rising as it transitions to a digital communications and entertainment content provider, but looking over its past 10 years of earnings growth, there really hasn’t been a great rate of change.

According to Peter Lynch, you wouldn’t find too many slow growers in his portfolio because of all the other strong growth opportunities that he could take up instead. However, generous and large dividends are the plus for this category’s stocks.

Category 2: stalwarts

Moving faster than the slow growers, stalwarts are market leaders in their industries, having established themselves over many years. They are still able to squeeze out growth by pushing into new regions and markets to keep up expansion. Classic examples of this type are Woolworths (ASX: WOW), Wesfarmers (ASX: WES) and BHP Billiton (ASX: BHP).

As the Australian population grows out along the continent, the two retail giants have expanded along with it. Their profit margins may only be in the single digits, but in the case of Woolworths, it has had a 10-year compound annual earnings growth rate (CAGR) of 13.7%. Wesfarmers achieved 16.7% and BHP was in the middle at 15.4%. BHP has been expanding into different resources like petroleum, as well as into various geographical areas for diversification and growth.

Category 3: fast growers

These companies are the ones that grow earnings 20% – 25% or even more per year. They can climb in share price multiples of 10, 20, 30 times or more. They may be in a hot industry, but they don’t really have to be. Their unique business style, some extreme competitive advantages, or sheer demand for their products or services boosts them up. Their growth may start in one city or region and then moves onto more and more regions.

One great example of this is REA Group (ASX: REA), the operator of realestate.com.au. Since 2004, the share price has grown from about $0.70 to $40.96, up a compound annual rate of 50.2%. Will it continue that way into the far future? I can’t say, but NPAT went from a negative $1.5 million in 2003 to $109.7 million in 2013.

Fast growers can also be like a chain store that every year expands its stores and regional locations. As long as they have space to expand into, then potential growth is there. One that comes to mind is Greencross (ASX: GXL), which is growing its veterinary services across Australia. It’s also acquiring smaller, privately run veterinary practices to help its greenfield expansion plans.

It has grown NPAT from $70,000 in 2007 to $3.54 million in 2013. It may not seem like a lot, but percentage wise, it is huge growth. The share price has gone from $1.50 then to $7.45 now.

Foolish takeaway

Before investing, before even making a short list of potential stocks you want to buy, categorise the companies and get an idea of what to expect out of them. No company can maintain high-growth constantly for decades. But by understanding the stage at which they are in their business life cycle, your expectations can be set appropriately. You need a good mix of stable companies and high-growth companies for a long-term winning portfolio.

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