Motley Fool Australia

How to Find a Growth Stock

There are a number of strategies investors can use to make money on the share market. A popular strategy is to buy shares in growth companies. Growth shares are businesses which are expected to grow profits and revenues at a faster pace than the general market. Companies that can do so for an extended period of time often see share prices climb. This rewards investors with returns via capital appreciation. 

It is important to remember that with reward comes risk, so it’s essential to understand the basics of growth investing and its risks before starting out on a growth investing strategy. Growth shares can fall more rapidly in a bear market, but with the appropriate strategy risks can be minimised. 

So if you’re looking to get into growth investing, how do you find ASX growth shares to invest in? Here are a few methods we use to identify ASX growth shares with the potential for major gains. 

Article last updated: 29 September 2020

What is a growth share, anyway?

A growth share is a company that is expected to increase revenue or profits at a faster rate than its industry or the market in general. Growth shares appeal to investors because the share market often values a company on a multiple of its earnings. As earnings increase, so should the share price. The faster earnings increase, the quicker the appreciation in the share price. Beyond profits and revenue, common traits of successful growth shares include large market opportunities and strong business models. 

Where to look for growth shares

If you look at high growth ASX shares, you will note that many did not exist even a decade ago, but have since become well known. Afterpay Ltd (ASX: APT)Appen Ltd (ASX: APX), and Xero Limited (ASX: XRO) started out as small players but have steadily increased their markets and customer numbers. This has helped drive huge growth in revenue, turning these shares into winning investments. 

So how do you identify the next Appen, Afterpay, or Xero while it is still in its infancy? One method is to think through your habits and see if you can identify products or services you are using regularly today that you haven’t used in the past. If you (or your friends) have fallen in love with a new product or service, there’s a decent chance the company behind it is worth investigating. 

Examples include: 

  • The move towards healthier food options and concerns about food security have benefited businesses such as A2 Milk Company Ltd (ASX: A2M) and Bubs Australia Ltd (ASX: BUB).
  • The rise of artificial intelligence and cloud computing has led to increased demand for machine-learning data supplied by Appen and cloud-based accounting software from Xero. 
  • Advances in infection control and decontamination have spurred demand for Nanosonics Ltd.’s (ASX: NAN) disinfection and sterilisation technology.
  • The trend towards purchasing online has led to increased revenue for online retailers such as Temple & Webster Group Ltd (ASX: TPW).

Think about your spending and determine if you can recognise any patterns. Are there stores that you didn’t purchase from previously but now do? Are there new technologies that you or your workplace are benefitting from? Have you become a major fan of a product or service? A simple internet search can help you find the companies behind the products and services you love. If the company is listed on the ASX and still in the early stages of growth, you may have stumbled on a potential winner. 

Keep an eye out for macro societal trends

The best growth shares tend to benefit from massive changes that ripple through society. Companies that can capitalise on trends that take time to play out will often see revenue and profits grow for years and can generate significant returns for investors. 

So what macro trends are happening now that investors can take advantage of? Here are a few we are following with great interest: 

  • Remote working: The coronavirus pandemic has resulted in huge numbers of office workers working from home for months. While the pandemic persists, remote-working arrangements are likely to remain popular. Even beyond the pandemic, many office workers have found they value the lack of commute and flexibility of working from home. Companies that facilitate remote working are the beneficiaries of this trend. Examples include LiveTiles (ASX: LVT), which provides software used to power corporate intranets, and Whispir Ltd (ASX: WSP), which provides a communications workflow platform that automates interactions.  
  • Online shopping: Online shopping has grown dramatically in Australia over the last 5 years. The coronavirus pandemic has accelerated this rapid growth. Lockdowns closed shops and consumers opted for the safety of home delivery, leading to a surge in online orders. Retailers with a strong digital presence such as Kogan.com Ltd (ASX: KGN), Temple & Webster, and Adairs Ltd (ASX: ADH) have seen sales soar as a result. 
  • Digital payment technology: Fewer Australians were paying with cash even before the coronavirus pandemic. Now, many businesses are actively encouraging customers to use digital payment methods. Increased online shopping has also seen the use of digital payment methods rise. Companies that are leveraged to this trend include payment systems provider Tyro Payments Ltd (ASX: TYR) and buy now, pay later providers such as Afterpay and Zip Co Ltd (ASZ: Z1P)
  • The rise of online advertising: Investment in digital advertising continues to grow as consumers spend more time online. With worldwide lockdowns, consumers are no longer exposed to outdoor advertising and are increasingly rejecting paper-based advertising. As a result, advertising spend is increasingly shifting to online channels. According to Statista, digital ad spend in Australia will reach US$7.526 million this year, which equates to US$370.34 per internet user. This creates huge opportunities for companies that can reach customers online, such as digital advertisers REA Group Limited (ASX: REA) and Carsales.Com Ltd (ASX: CAR).

These are just a few of the macro shifts taking place in society. Next time you notice one happening, do some research to see if there are any companies set to benefit from the trend. 

Piggyback on the legends

Growth-16.9

Fund managers usually have huge research budgets that they use to find great businesses. They also issue quarterly and even monthly reports on their holdings. You can take the opportunity to look through their recent buys and sells to see which ASX shares they are favouring. 

While not every fund manager is worth following, there are several that can be a great source of investing ideas. A few of our favourite growth investors are: 

  • Hamish Douglass of Magellan Financial Group Ltd (ASX: MFG): Douglass has years of investment experience. His investment philosophy centres on investing in a concentrated portfolio of the world’s best businesses, purchased at attractive prices. 
  • Josh Clark of QVG Capital: Clark started out as a quantitative analyst and his long short fund was crowned the number one Australian equities strategy in 2020 according to a survey on investment manager performance.  
  • Mark Arnold of Hyperion Asset Management: Arnold has a philosophy of investing in high quality growth businesses over the long term. This has paid off with the Hyperion Australian Growth Fund delivering returns of 19% in FY20.  

There are a number of websites which track the performance of Australian fund managers including Investsmart and Canstar. Growth investors can visit these sites for updated performance metrics on Australian managed funds. Looking into the recent buys and sells of top performing funds can provide some quality ASX share ideas for individual investors.

Stock screening tools

Another reliable source for unearthing promising ASX growth shares are free stock screening tools. These tools allow investors to sort ASX shares by certain parameters, which can help identify if a company can be considered a growth share. For example, Investing.com allows users to sort ASX shares by yield, P/E ratio, profit margins and sales, among other variables. Here are a few parameters that can be used to screen the market for growth shares: 

  • Market cap: this metric is a quick way to measure a company’s size. If you dislike small cap shares, you can use this metric to screen them out. You can also use this metric to identify large cap shares in your area of interest. As a rough guide, shares with a market cap of more than $100 million will generally appear in the ASX 300. 
  • Profitability: companies that consistently generate profits tend to be less risky than those that are burning through capital. For this reason, many investors favour growth shares that have already crossed over into the black. A quick way to screen for profitability is to set the P/E ratio to a positive number. This will screen out any shares that have not yet produced positive net income. 
  • Sales growth: the best growth shares are capable of growing profits for years to come. To do this, they need to be able to increase revenue and sales reliably.
  • Projected profit growth: ASX analysts are paid handsomely for following companies closely and publishing reports that predict their growth rates over the next several years. Although these predictions can be inaccurate, they are useful in gauging what the market expects from particular companies.
  • Sector: Some sectors are harder places for investors to make money than others. Some prefer to avoid commodity industries in favour of sectors where companies can build a lasting competitive advantage. Technology, healthcare, services, and financial sectors can provide fertile fishing grounds. Nonetheless, it is important that investors understand the industry they are investing in. Make sure you do your research and have a decent level of knowledge about how the relevant sector operates.
  • Balance sheet: While debt isn’t always a bad thing, some investors prefer to avoid companies carrying large amounts of debt on their balance sheets. You can use the debt-to-equity ratio to eliminate highly indebted companies. This ratio compares a company’s total debt to its shareholder equity. A good rule of thumb is to set the debt-to-equity ratio to below 30%. Obviously, the lower this number the less debt. While you may prefer to be conservative when it comes to debt, keep in mind that some industries naturally use more debt than others, so be careful when comparing ratios across industries. 

With these parameters in mind, let’s run a share search using the following criteria: 

  • Market cap over $100 million
  • Profitable with a positive P/E ratio 
  • Positive 5 year sales growth
  • Positive revenues 
  • Earnings per share growth over 5 years  
  • A debt to equity ratio below 0.3 

Investing.com identified 132 companies that match these criteria. Here’s a look at the top 10 by market cap: 

Company

Market Cap

Industry

ASX Ltd (ASX: ASX)

$15.66 billion 

Diversified financials

Magellan Financial Group  Ltd (ASX: MFG)

$10.38 billion 

Diversified financials

Beach Energy Evolution Mining Ltd (ASX: BPT)

$3.17 billion 

Energy

Pro Medicus Ltd (ASX: PME)

$2.61 billion

Healthcare

Kogan.com Ltd (ASX: KGN)

$2.15 billion 

Retail

Zimplats Holdings Ltd (ASX: ZIM)

$1.03 billion

Materials 

Mount Gibson Iron Limited (ASX: MGX) 

$856 million 

Mining

OptiComm Ltd (ASX: OPC)

$627 million 

Communication services 

Infomedia Limited (ASX: IFM)

$589 million 

Software & Services 

Tribune Resources  Limited (ASX: TBR)

$427 million 

Materials 

While there is no bulletproof formula for creating a list of great ASX growth shares, using screening tools can be a great way of identifying potential winners. It can also be a good way of discovering growth companies while they are still small. When companies are in the early stages of their growth cycle, investors can get in on the ground floor. 

Altium is one example of a dynamic growth share you can discover using screening tools like Investing.com. Altium’s revenue increased 10% in FY20 while profit increased by 12%, despite the coronavirus pandemic.

So what does Altium do? The company provides software used to design printed circuit boards (PCBs). PCBs are used in the vast majority of electronic devices. With the rise of the ‘internet of things’, more and more devices are interconnected, so require the design of PCBs. Altium plans to transform the PCB industry by achieving market dominance. 

Altium’s subscriber base has grown in leaps and bounds over recent years. In FY20, Altium reported record growth of 17% in its subscription base with 51,006 subscribers. This exceeded the company’s goal of 50,000 subscribers at the end of the financial year. By 2025, Altium aims to achieve 100,000 subscribers and US$500 million in revenue.  

Altium’s subscriber numbers 

2HFY19

1HFY20

2HFY20 

43,600

46,693

51,006

 

The strong growth in subscriber numbers has brought corresponding increases in revenue. This metric grew by 10% in FY20 % and 60% of revenue is now recurring.  

The coronavirus pandemic has been a catalyst for Altium’s pursuit of market dominance and transformation. The company recently launched its new cloud platform, Altium 365, which is gaining strong early adoption. Its Altium Designer program is the most widespread PCB design tool and is used by over 100,000 engineers worldwide. Altium is forecasting an acceleration in revenue growth between 2021 and 2025, with EBITDA margins predicted to reach up to 45% in 2025.    

One of the benefits associated with Altium is that the company has already grown big enough to start generating meaningful profits and cash flow, which helps lower its risk profile. Altium products have historically been positioned as lower-cost and easier to use than those of competitors, but less suited to complex projects. This is changing, however, as Altium has released products aimed at the higher end of the market. 

Altium has almost doubled subscriber numbers over the past 5 years. Over the same period, revenues have increased at a compound annual growth rate of 19%. Earnings per share have increased from 16.9 US cents in FY16 to 42.45 US cents in FY20. The company has strong momentum towards its 100,000 subscriber goal, which should help carry it into a dominant industry position over the next few years.

The risks of investing in growth shares 

While investing in growth shares can be great, there is a catch-22 that investors should be aware of. When the market believes that a company is going to rapidly increase profits, it is usually rewarded with a high valuation. This greatly increases the risk that the share price could fall dramatically if it fails to meet expectations. That’s one reason why investors should know the fundamentals of growth shares and do their homework before diving in. 

Let’s circle back to Altium to see this in effect. As at the time of writing, Altium is trading at more than 100 times earnings and has a dividend yield of just 1.16%. These numbers are high and low, respectively, when compared to the S&P/ASX 200 Index (ASX: XJO) averages. This raises the risk profile of Altium significantly. If the company fails to deliver on investors’ growth targets, the share price could fall significantly.

Another risk that investors need to be mindful of is that growth shares are usually much more susceptible to wild price swings in turbulent markets than value shares. Volatility can be unnerving at times, so if you can’t handle big price swings, growth investing might not be for you. 

Is growth investing right for you?

Using these methods will help you uncover dozens of shares that hold growth potential. Of course, finding growth shares is one thing. Having the conviction to buy them and then hang on through thick and thin is another. If you can learn to do so successfully, however, you’ll put the power of compound interest on your side and be in a great position to generate meaningful wealth over the long term. 

Figures correct at 29 September 2020. Kate O’Brien contributed to this report and owns shares in Appen Ltd and AltiumThe Motley Fool Australia’s parent company Motley Fool Holdings Inc. owns shares of Temple & Webster Group Ltd and Tyro Payments. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. recommends Pro Medicus Ltd. The Motley Fool Australia owns shares of and has recommended BUBS AUST FPO, Nanosonics Limited, Pro Medicus Ltd., and Washington H. Soul Pattinson and Company Limited. The Motley Fool Australia owns shares of A2 Milk, AFTERPAY T FPO, Altium, Appen Ltd, WiseTech Global, and Xero. The Motley Fool Australia has recommended Crown Resorts Limited and REA Group Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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