How Much Should You Pay for a Growth Stock? (Part 2)

What can we learn about growth stock investing by examining the record of 50 of the best stocks from the previous 15 years? A lot, in our view. In this second part of our research, we draw some conclusions from our sample and suggest some ideas for identifying growth when it's still attractively priced. Click here for Part 1, which details our methodology and data table.

Preliminary Conclusions and Commentary
While the data mostly speak for themselves, we'd like to highlight four thematic--if preliminary--conclusions.

1. At times, the best growth stocks can be surprisingly cheap.

According to our research, the four cheapest stocks in our 1995 sample were  Chico's (CHS),  Apollo ,  Dell , and  Whole Foods Market . And from where we stand, the discounts are astounding. Investors could have paid up to 40 times more for Chico's before underperforming the S&P 500. For Dell, they could have paid 18 times more, and for Whole Foods, about 6.5 times. Real growth may be rare, but it can be extremely valuable.

2. Don't be scared away by a high P/E ratio.

Morningstar values stocks using discounted cash-flow models, as we believe cash is the ultimate source of shareholder value. You can't spend "earnings" in any store we know of. Focusing on cash also helps avoid many accounting shenanigans and earnings-management techniques. But most importantly, using cash flow helps lift the "earnings veil" to uncover attractive growth stocks. For example, while many investors shy away from stocks with high P/E ratios, our research concludes that this isn't always wise. And while P/E ratios for growth stocks must eventually decline, this can take years to happen--by which time the "E" can be several times larger. For example, investors who bought  Qualcomm (QCOM) at a P/E of 78 in 1995 have earned tremendous results. And as we illustrate, those investors could have paid up to a P/E of 577 before they would have underperformed the S&P 500. Similarly, investors could have happily bought  Starbucks (SBUX) at 62 times earnings (maximum P/E 298) or  Fastenal (FAST) at 41 times earnings (maximum P/E 80) and done magnificently. For the right company, growth is most assuredly worth "paying up for."

And the highest maximum P/E ratio we've found thus far? That honor rests with  Dell , which we estimate warranted an astounding P/E of 2,060 on Jan. 1, 1990--and, no doubt, some impressive foresight, as the actual P/E was a mere 14. And although  Berkshire Hathaway (BRK.A) (BRK.B) didn't make our list of 50 growth stocks, we couldn't help but peeking at its maximum 1995 P/E ratio--a seemingly high 64, much more than the then-prevailing 48. Perhaps there's hope today for  Google (GOOG), even at its sky-high current P/E of 72. 

3. Don't chase growth; buying with a margin of safety remains crucial.

We're most definitely not recommending indiscriminate growth investing. For one thing, our 50-stock sample exhibits a heavy quality bias. What's more, several of these growth stocks were significantly overvalued in 1995.  Motorola (MOT) may have sold for $17.30, but an investor who paid more than $5.88 per share would have dramatically underperformed the S&P 500. Even more popular names like  Coca-Cola (KO) and  Bristol-Myers (BMY) were unattractively priced in 1995. But there's no just no need to overpay. Over time, we're sure to find plenty of stocks that offer an attractive growth margin of safety--a margin between the actual and the warranted share price. By our count, about 78% of our 1995 cohort was attractive.

4. Growth comes in many forms, not just technology.

It may be a minor point, but we often find investors will far too readily associate growth exclusively with technology stocks. As we hope our sample illustrates, growth can come in many markets--from regional banking, specialty retail, food distribution, organic supermarkets, consumer products, insurance, and even the local pharmacy. Don't limit your growth research to the "traditional" sectors.

Finding Growth When It's Still Cheap
Obviously, the key to successful growth investing is buying when growth is still cheap, and sifting out the wannabes. In our view, this is far from simple, and some luck will always be involved. That said, we think there are steps investors can take to improve their odds of landing the big one. While uncovering techniques for discovering growth early is an ongoing focus of our research, we can recommend that growth investors pursue firms with an emerging moat, growing secular demand, and growth-oriented management. This is a framework we're working to improve. As we've seen, the payoff can be massive.

1. Emerging Moat: The Competitive Advantage to Come

When searching for potential winners, we're most interested in uncovering firms that don't yet have moats, but are widening what they already have. Perhaps the competitive dynamics are yet to stabilize or the firm lacks scale--but wide-moat potential is evident. Either way, we're aiming to board on the ground floor of the moat elevator. While we're often conditioned to think of growth in terms of sales or margins, an emerging moat provides bountiful opportunities to reinvest cash flows for very high returns. In retrospect, Chico's is a very good example, as the extra stores the retailer opened during the last decade clearly earned excellent shareholder returns. But which firms could have an emerging moat today? Mike Trigg, Morningstar's growth equities strategist, publishes a list of emerging moat stocks each month in Morningstar GrowthInvestor.

2. Growing Secular Demand 

We define this as expanding and sustainable demand for a firm's products. Growth companies that enjoy growing secular demand will usually thrive in good and bad times, and often fulfill an unmet need or supply a superior product. Often growing secular demand can be found by constructing large investment themes. For example, the soon-to-retire baby boomer demographic is boosting retirement savings demand, helping asset managers like  T. Rowe Price (TROW) and  Eaton Vance , and the ever-compounding demand for U.S. housing is helping  Toll Brothers (TOL) and  Fidelity National Financial (FNF). As for servicing an unmet need, we often find this in new markets enabled by technology. The best of all worlds might be  Google (GOOG), which compounds an unmet need with a superior product.

3. Growth-Oriented Management

It's hard to sustain long-term growth without a motivated management team whose interests are appropriately aligned with those of shareholders. Growth often demands that management reinvest a substantial portion of a firm's cash flows--but it can be difficult to sacrifice current earnings for a distant return. Only a management team with appropriate incentives--such as a substantial personal investment--will wholeheartedly pursue these opportunities. If your management team is rewarded by earnings per share growth, you may be disappointed by the lack of earnings sacrifices. Growth investors should also covet management teams that are willing to tap new markets as older products mature. Where would  Apple (AAPL) be today if management hadn't pursued the iPod?

What's Next?
So the best growth stocks are worth a lot, and you shouldn't needlessly fear investing at a high P/E ratio--as long as a margin of safety is present. But where are today's best growth stocks, and how can investors spot them early? It's a little like searching for the holy grail of investing, but that's where we plan to focus our subsequent research. In the meantime, we'd recommend a trial subscription to GrowthInvestor, where we list Morningstar's current favorite growth companies. We're also aware that Jeremy Siegel performed a similar study on the "Nifty Fifty" in Stocks for the Long Run (Page 152 of the third edition), so we'll cheerfully recommend a review of that research as well.

We'll update our growth research as we learn more.

Thanks to Tony Wiedenski and Noah Singer for helping compile and analyze a veritable mountain of data.