Common Traits of the Best Stocks

The best growth companies to invest in share a set of common characteristics.

You face a bewildering array of choices when you pick stocks. When looking for stocks to buy to meet long-term financial goals, however, you can narrow the field quickly. For an individual investor who works full time and who wants to follow a consistent investing strategy to find stocks, growth stocks are the best ones to buy. These companies are easy to identify and they share a set of common characteristics.

Seek Growth Stocks With Above-Average Sales and Earnings Growth

Growth stocks increase revenues and earnings at faster rates than that of the general economy and most competitors in the same industry. The best stocks to buy are those of companies that tend to continue growing even when business conditions are weak; their growth might soften during these times, but they do better than their competitors. They also can outlast their rivals in downturns and thrive when the economy bounces back. Stock prices tend to follow a company’s earnings growth.

Consistent growth is also a plus. BetterInvesting’s online stock selection and analysis tools include a graph of sales and earnings growth. Graph lines that go up and are straight are generally preferred to those that are shaped liked roller coasters. The consistency of growth is a sign of quality performance by the management team.

It’s important to consider growth in context of company size. You should expect smaller companies to grow at faster rates than larger ones. Look for small companies of less than $1 billion in annual revenues to grow sales and earnings at 12% or more a year. Midsize companies, with $1 billion to $10 billion in annual revenues, should be growing between 7% and 12% a year. Expect large companies, those with annual revenues above $10 billion, to grow by at least 5% a year.

Pick Stocks With Stable or Growing Profitability

A company’s above-average sales and earnings growth indicates that its management is solid. Another test of management is stable or growing profitability. Eroding profit margins, the percentage the company gets to keep of what it makes in sales, can be a sign that the company is in trouble. Find stocks of well-managed companies that can find ways to keep this from happening, such as by increasing prices or lowering costs. (By the way, when considering profit margins, look for the profitability before taxes. Management has limited capability to control tax rates.)

Stable or steadily increasing pretax profit margins show that management can balance growing sales while containing or even decreasing costs.

Another test of management is the percent earned on equity, or return on equity, or ROE. That’s the return management achieves on investors’ money (including earnings retained in the business). ROE indicates how well management is employing a company’s resources contributed by shareholders’ money and earnings invested back into the company to create new assets that grow sales. The best stocks to buy are those of growth companies with stable or growing ROE.

Check a company’s pretax profitability and ROE histories against those of competitors. You want to find stocks that are the best in their industry for these management measures. BetterInvesting members get stock ideas from our online tools, education, and resources, which you can sample free.

You should also study company debt. High debt levels can be risky, because companies continue to pay debt obligations regardless of business conditions; conditions can become so severe that a company can no longer pay its debt and goes out of business. In general, look for stocks to buy of companies with a ratio of debt to total capital that’s less than 33%.

There are exceptions, though. Compare a company’s debt percentage to the industry average. Some industries, such as banks, financial institutions, and utilities, typically operate using higher levels of debt. Some successful companies in other industries have proven they can carry high debt over many years.

Buy Stocks With Reasonable Price-Earnings Ratios

Once you’ve determined you’re studying a quality company, you’ll need to make sure you're selecting a stock to buy that's selling at a reasonable price. We walk through BetterInvesting’s stock analysis process, which helps you identify investments with suitable return potential, in How to Pick a Great Stock.

Paying too much for a great growth stock will hurt your long-term return. The cornerstone of stock price analysis is the price-earnings ratio. The P/E is the price you’ll pay for a dollar of a stock’s earnings and helps you compare stock prices.

Study the current price-earnings ratio — the earnings per share from the past four quarters divided by the share price — relative to the P/E history to help determine whether the stock is selling at price that will help you employ your investment strategy.

Stocks selling at wildly high P/Es — say, 50 and above — tend to provide poor returns. Stocks with P/Es above their historical range can also prove disappointing.

BetterInvesting’s online programs for stock selection and analysis can help you make sense of this data and walk you through the two key questions to ask:

• Is this a well-managed growth company?
• Is the stock selling at a reasonable price?