We’ve seen a few growth shares climbing over the past couple of years. Even after dropping back recently, many are still well in profit. Look at crypto miner Argo Blockchain. Argo shares have slumped 60% in the past 12 months, but are still up nearly 1,000% over two years.
How can I pick the long-term winners while avoiding the short-term crashes? Here are five rules of thumb I’ve picked up to help me find the growth winners while avoiding the losers.
Beware of the crowds
I often don’t hear about growth shares until everyone else has. By the time I know, even people who usually don’t invest in shares are talking about them. And tipsters out there are making wild claims about how high the price is set to soar.
For me, that’s the time to stay away. It so often coincides with a peak in the share price, caused by everyone getting on board. And a subsequent crash is all too common.
Valuation is essential
We frequently see growth stocks on very high P/E valuations. And I’ve heard investors claim that valuation doesn’t matter when it comes to high-flyers. But I feel that’s nonsense. Valuation always matters.
The difference is that some growth stocks go on to justify their early high P/E multiples, while others don’t.
There’s a handy measure used for growth shares, the PEG ratio. It compares the P/E with forecast earnings growth rates, and smaller is better (other things being equal). Investors typically look for a value below 1.0, ideally 0.7 or lower.
Misleading early profits
Recording a first profit is a positive early sign. It can remove a lot of risk associated with the unprofitable start-up years. But early profits require close inspection.
There’s a recent example in hardwood producer Woodbois, which turned in a profit for 2021. But investigation shows it was all due to one-offs in that year’s accounts, and there’s actually another underlying loss there.
I want to see positive underlying profits, generated from a company’s actual daily business.
What goes up
I’ll never forget a friend once saying to me: “You know how to buy a share that’s already gone up, don’t you?“
The old saying that what goes up must come down is obviously not always true. But it very often happens with growth shares. Sometimes over and over. So if I’m considering buying a share that’s been on a bull run, I ask a key question. How much further growth is there left for me?
It comes down to how I see the current valuation, regardless of what the share price has previously done.
Second chances
Finally, I forget the number of times I’ve missed the boat with growth shares. But in almost every case, there’s been a second chance some time later.
Growth stocks can be among the most volatile. And so often we see big falls following the early big gains. So, I won’t buy a growth stock at a valuation that makes me uncomfortable just to avoid missing it.
No, I’ll wait for possible future dips. And if they don’t arrive, well, there’ll be other growth stocks coming along soon enough.