With demand exceeding supply, strong pricing power and the Government increasing spending on infrastructure, construction companies are likely to be some of the best performing growth stocks in the coming year
This Christmas, investors will be asking Santa for only one thing ' that a change of year brings about a change of fortune.
During 2002, expectations of a sustainable global economic recovery have been left unfulfilled, accounting scandals have called into question the authenticity of published profit figures and now prospects of war in the Middle East have added to market uncertainty. The result of all this is that equity markets are heading for their third consecutive year of declines.
Within the current investment environment that we are now experiencing, picking the right stocks has never been more important. Whether you are a private investor or a fund manager, you need a strategy for picking stocks.
When stock markets are on an upward trend, the share prices of most companies will benefit.
However, in unpredictable times only the strongest companies will continue to do well. We are not talking flavour of the month companies, but those that have quality management, good financials and a solid business plan.
So how do you find such stocks? Of the many investment strategies around today, one to consider is growth investing. Now, while most investors may feel growth is dead and they do not want to get burnt again, they may wish to reconsider.
Growth investing is all about investing in companies that are growing and will continue to grow at above-average rates. The perfect growth company will build up revenues and earnings over the years regardless of economic conditions.
However, since the technology bubble burst in March 2000, things seem to have been going from bad to worse for growth investors. It is important to realise that the 1990s were an exceptional time for the stock market and while no one expects a repeat of those heady years, conditions at present remain favourable for good quality growth stocks with quality being the operative word.
In the late 1990s, it was possible to make a very quick buck on the back of technology stocks as investors tried to find the next big thing. There was no regard for quality and investors got carried away, pushing share prices to unrealistic levels.
Those fast money-making opportunities are long gone and unlikely to make a rapid return. However, there is more to growth than just technology.
The opportunity now available to investors is to construct a long-term growth portfolio from a range of sectors that should be able to weather short-term volatility and produce handsome returns over five to ten years. Picking the right stocks is therefore paramount.
So what should you be looking at when considering the merits of a particular growth stock? There are a number of factors, some of which are subjective, that can help identify potential winners.
One of the defining attributes of a growth company is a rapid acceleration in its revenues. Rising revenues tend to correlate with rising share prices. If a company's revenues are increasing, this is a sign that it has a product that is in demand.
This fits in with one of the key things we look for when investing in company ' that demand should exceed supply. This gives a company good pricing power, ensuring revenues will rise at an above average rate. However, it is important to investigate the source of revenue growth. Growth should ideally be organic and not through acquisition.
Obviously growth in revenues should be accompanied by profits ' otherwise what's the point? During a company's early years of profitability, earnings growth can often outpace revenue growth. As profits climb over the years, this rate will generally fall in line with the rate of revenue growth.
The trick therefore is to be invested at the early stages and benefit from the rapid levels of earnings growth before the company matures and growth tails off. The P/E ratio is the most favoured of investors' valuation tools. Growth companies have P/E ratios above the market average because their earnings are expected to grow faster.
Most people use historic earnings to work out this ratio, but as investing in shares is all about the future, it is better to use forecast earnings figures.
But beware ' forward P/E ratios are only as good as the earnings forecasts being used. Furthermore, numbers are again not very comparable across different sectors as different industries operate at different levels.
A company's level of cashflow is another way of measuring its financial strength and the quality of its earnings. It is a measure of how much cash is being generated. If cashflow is significantly different from earnings, then the stated earnings may be unreliable. We tend to look for companies that have a positive cashflow.
Cashflow statements can also help identify a company's accounting methods. Companies are often under pressure to show strong sales and profit growth and can employ some creative accounting to keep investors happy. Companies that can prove their growth through the use of conservative accounting are the ones to go for.
This is a measure of how much money a company is making relative to how much it has invested.
Again, numbers are only comparable within the same sector.
One factor that determines a company's ROC is its debt levels and this highlights another of our important investment criteria.
A company should have prudent and manageable debt levels and not be overly stretched. A company with high earnings but a low return on capital is too reliant on borrowings, putting it at risk if, for example, interest rates rise.
The best growth companies are often the top players in their industries or those market share is rapidly growing. Market share is an important attribute and the bigger this is the better the company's pricing power will be.
The criteria we have looked at so far are all quantifiable. Judging the quality of management is subjective. However, it is probably one of the most important factors we consider when making an investment decision. Good management is absolutely crucial for fast growing companies in fast changing environments.
So where should we be looking to find these companies?
One of our favoured sectors at the moment is construction and building materials. At first glance this would appear to be a classic cyclical sector and, with doomsayers predicting an imminent crash in the housing market, not the first choice of investment for growth investors.
However, we believe that there are plenty of long-term reasons of investing in this area of the market. While house prices cannot continue to defy gravity, they are likely to remain relatively robust and we are unlikely to see a repeat of the price falls of the late 1980s and early 1990s.
The sector meets several of our important criteria in that demand exceeds supply and pricing power is strong.
The UK is experiencing a housing shortage that will take several years to correct and, with planning permission to develop potential sites becoming increasingly difficult to obtain, the demand/supply equation should remain favourable.
The housing market aside, there are other long-term attractions for the sector. These companies will also be beneficiaries of the Government's plans to increase infrastructure spending over the next few years.
In his pre-budget speech, Gordon Brown confirmed that the public spending plans for a better transport network, more schools and more hospitals, announced earlier this year, were still on track. Furthermore, Tony Blair recently reiterated his commitment to the Private Finance Initiative (PFI). Companies we expect to do well include Balfour Beatty, Carillion and Taylor Woodrow.
Strength in the housing market and the availability of cheap credit has buoyed consumer spending this year. As well as retailers, entertainment and leisure companies have also benefited. Within leisure, betting and gaming companies are set to be long-term winners. The biggest changes to the UK's gambling laws for 30 years will see a dramatic deregulation of the gaming industry.
Those who want to cash in on this over the next few years should take a punt on companies such as Stanley Leisure and William Hill. So, as can be seen there's more to growth then technology. Those who ignore growth now do so at their peril.
Stock market investing is for the long-term and it is often after periods of considerable market weakness such as we are now experiencing that the best opportunities can arise.
Many companies look set to exhibit above average revenue and earnings growth over the coming years and many of the winners could come from the mid cap area of the market. Get in while you can.
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