How to Find a Great Growth Stock

As editor of Morningstar GrowthInvestor, I'm constantly searching for the great growth companies of tomorrow. To help me in my search, I've put together a set of five principles that form the foundation of the investment process at GrowthInvestor, and Morningstar's take on growth investing.

1. Significant Market Potential
Last year, I had the pleasure of once again reading Common Stocks and Uncommon Profits, as I wrote a chapter on Philip Fisher for Morningstar's Investing Workbook Series. The first of Fisher's famous "15 Points" for investors to consider is whether a company has products with sufficient market potential to drive substantial sales increases for several years. I completely agree--a company cannot sustain growth unless it addresses large and expanding markets. For example,  Apple's (AAPL) sales have more than doubled over the past five years because the iPod addressed the sizable market for portable audio devices (as demonstrated by the prior success of the  Sony (SNE) Walkman).

In assessing market potential, I've found it useful to ask this question: What exactly does the company do? While this question is basic enough, it will correctly frame your thinking, and that can make all the difference. Many people thought of  Amazon.com (AMZN) as merely a bookseller, comparable to  Barnes & Noble  in the offline world, because the company started off selling only books and was commonly described as an "online bookstore." However, thinking about Amazon as a very efficient retail distribution system, like a less-capital-intensive version of  Wal-Mart (WMT), would have helped you realize that the company's addressable market was much larger than just books.

2. Growing Demand
Because we're looking for businesses with the potential to increase sales several times over, I am only interested in companies that benefit from growing demand for their products or services. Some companies may grow through acquisitions or by taking advantage of temporary supply/demand imbalances, but at the end of the day, these types of growth are unsustainable.

Growing demand can be driven by factors such as a favorable demographic trend or disruptive innovation. I am also interested in two other areas: services essential to society and consumer products or brands with the potential for universal appeal. As an example of the first, information processing and communication is vital to civilization, and I'd wager that demand for information services has increased every year in modern history. In the past few decades,  Microsoft (MSFT),  Intel (INTC), and  Cisco (CSCO) have created $535 billion of wealth because they capitalized on the value of information in their respective domains. I'm not certain what forms information will take in the future, but I do know that demand for information services will continue to increase because of its central role in society.

Few products are as universally accepted as  Coca-Cola (KO) and it's easy to see why demand has grown steadily for more than a century. Humans must drink to survive, and Coke offers a stimulant-filled liquid with a distinctive taste that is associated through personal experience and endless marketing with all things right and true. As Pavlov illustrated with his famous experiment, association is a powerful force in shaping behavior.  Blue Nile , a GrowthInvestor portfolio holding and "emerging-moat" company, has an excellent opportunity to associate its brand with a very happy event in many people's lives: the marriage proposal. I think this positive association, along with Blue Nile's premium product and superb service, will generate an increasing amount of referrals and repeat business. A consumer business that both serves a universal need and can pull psychological strings wields an impressive combo and is likely to enjoy growing demand for many years.

3. An Economic Moat
Capitalism is a brutal playing field. Rapid growth will always attract competition, so it is important to only invest in companies with strong and enduring advantages. Do you remember Altavista, Northern Light, Magellan, or Hotbot? At one point or another, these were hot search engines, but all faded into oblivion because they could not build an economic moat.

One of the unique features of GrowthInvestor is our focus on "emerging moat" companies. As investors, we should remember that a company's value is determined by what happens in the future and not by past successes. The truly outstanding rewards will come from identifying companies in the early stages of building ever-stronger advantages over the competition. These emerging-moat companies have the potential to one day walk among the Intels and  Home Depots (HD) of the world and create significant shareholder wealth along the way. This is why we own many companies with emerging moats in our GrowthInvestor portfolio. The road may be bumpy, but if the competitive dynamics play out favorably, these companies will reward us for many years to come.

4. Growth-Oriented Management
A great growth company must have a management team that is willing to pursue and execute on new opportunities. After a trip to Italy where he noticed coffee bars on every corner,  Starbucks' (SBUX) chairman Howard Schultz unsuccessfully tried to convince the company's founders to enter the retail coffee shop business. Schultz eventually purchased Starbucks for $3.8 million, executed brilliantly, and the rest is coffee-flavored history. Even in 2001, when Starbucks already had annual sales of $2.6 billion, Schultz had this to say: "Despite the success that Starbucks has enjoyed in the U.S., we have a less than 6 percent market share of coffee consumption. We are in the infant stages of the growth of the business even in America. And now seeing what we've done internationally we are going to shock people in terms of what Starbucks is going to be." He was right--Starbucks' sales reached $6.3 billion in 2005.

I also want a management team that takes a long-term perspective and is willing to sacrifice profits today for even greater profits tomorrow. However, management must also have the discipline to eschew a growth-at-any-cost strategy. A business that sells $1 bills for 50 cents will destroy shareholder wealth, even if its growth rates are phenomenal (as I assure you they will be).

5. Margin of Safety
There are few words more important in investing than "margin of safety." Many investors tend to get starry-eyed and overpay for growth, but that is a dangerous game. You can buy the greatest business in the history of the world, but your returns will be disappointing if you pay too much for it. By requiring a margin of safety, or a discount from Morningstar's estimate of intrinsic value, for every investment we make, we avoid overpaying for growth and allow errors in our forecasts.