A decade ago, value investors were complaining that large cap, blue chip stocks such as Wal-Mart, Coca-Cola, and Home Depot, were extremely overvalued, while momentum investors were buying those shares like crazy. Today, large organizations pay higher dividends and engage in stock repurchase programs; yet, in some cases, they have underperformed more than 60%. Even if the broader financial environment has created relatively unstable markets, on what grounds should you pick large-cap growth stocks?
Growth investing seeks for growth stocks of companies with earnings that are expected to grow at an above-average rate over the coming quarters, compared to the industry average and the entire market. Unlike value investors who look for undervalued stocks that are expected to rise in the short-term, growth investors focus on the growth potential of the company and are not interested in the stock price. Therefore, they are seeking for overvalued stocks believing that the intrinsic value of the company will grow in the short-term.
Overvalued stocks may be corrected either through a decline in the share price or through the equity price standing still until the intrinsic value equals the market value. So, one way to pick large-cap stocks is to consider that, as more capital and cash flow build up behind overvalued shares, value investors have the opportunity to buy giant U.S. companies at prices that haven’t been available before.
How to invest in growth stocks
Growth investors invest in rapidly growing companies with considerable revenues and profits. The idea is to receive a high rate of return on investment from the increasing share price. Although investing in growth stocks differs from industry to industry, there are common stock-picking strategies that take into account the following factors:
- Historical growth rate: according to the National Association of Investors Corporation (NAIC), large cap growth stocks are attractive when they display an average growth rate of 12% over the last five years. More specifically:
- Companies with a market cap higher than $4 billion should display a minimum growth of 5%,
- Companies with a market cap between $400 million and $4 billion should display a minimum growth of 7%, and
- Companies with a market cap lower than $400 million should display a minimum growth of 12% over the last five years.
- Projected growth rate: large companies typically display a growth rate of 5% -7% while a projected 5-year growth rate of 15% is considered ideal. However, projections may not be accurate or may be biased. Investors should always check the reliability of the source, but they should also have a fundamental understanding of how the market works. For instance, it is almost impossible for a large cap company to grow at the same rate as a growth-oriented start-up. Also, it is important to know how a particular industry or sector works and what are the growth prospects.
- Earnings per share (EPS): Pre-tax margins should exceed the past ten-year average and the industry average to indicate that the company translates its sales into earnings and controls its costs efficiently.
- Return on equity (ROE): large cap growth companies typically have a higher ROE than an industry average over a five-year period, indicating that these companies are profitable and capitalize on the money invested by their shareholders to produce earnings.
In conclusion, investing in large cap growth stocks requires a good knowledge of the market and the industries at hand. Growth investing suggests selecting the stocks of companies that display above-average growth and trade at high stock prices. On the other hand, investors should take into account the risks involved in trading at a higher stock price expecting that the company will display high growth as well. In fact, if the company’s growth rate is below expectations, the stock price will decline sharply, leading to huge losses.
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