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Fast Growing Stocks Best For Slowing Economy

Many analysts are predicting a weakening economy, and hence, a falling stock market, next year. They cite high energy prices, rising inflation, and a slowing housing market as reasons for their glum outlook.

Whether the naysayers are on the mark or not is anybody’s guess. But, since successful investing is about reducing risk, it pays to take their concerns into account, just in case.

What kinds of stocks should you have in your portfolio if the economy weakens?

Conventional wisdom says stick with companies that make or sell the products typically found in a grocery store such as food products, soap, and bathroom tissues. Consumers can put off buying a new car or a flat-panel TV, but they still have to buy the day-to-day necessities.

That may be true, but I have a different take.

Fast Growers Do Best
If the economy does slow, mature companies that are close to saturating their markets such as the likes of Safeway or Proctor & Gamble will likely still see their sales growth slow. But, a company with a hot new product that is just coming to the attention of prospective buyers probably won’t even notice that economy has turned down.

Thus, in a slowing economy, you’ll do best owning small-companies that are in the beginning stages of exploiting a new market opportunity. Another plus, if the economy doesn’t slow, these stocks will still do even better.

Screen for Fast Growers  
You can use screening to find companies that fit that bill. If you’re not familiar with the term, screening involves using search programs available on several financial websites to find stocks that meet your specific requirements.

I’ll use Business Week’s Advanced Stock Search to demonstrate the process. Business Week’s screener is free, and it’s more user-friendly than most.

Note: as of 1/17/07, Business Week's screeners were no longer available. You can run similar screens using MSN Money's Deluxe Screener (moneycentral.msn.com) or Reuters Investor's PowerScreener Lite (www.investor.reuters.com). MSN's screener requires downloading special software and Reuters' screener requires registration, but both are free. 

Get there from Business Week’s homepage (www.businessweek.com) by selecting Investing and then Stocks. From there, scroll down to Investing Tools, select Stock Screeners and then click on Advanced Stock Search.

You program the screener by filling in minimum and/or maximum values for data items that you want to include in your screen. The program assumes that you don’t care about any items that you left blank.

My screen relies mainly on analyst’s earnings forecasts to identify fast growing companies. But, stocks without a track record of strong recent earnings growth are risky business.

Start With Growth
So, we’ll start by specifying a minimum 20 percent annual earnings growth for the last reported fiscal year. Do that by entering “20” for the minimum value of the search parameter labeled “EPS Growth 1-Yr.”

For forecast earnings growth, specify a minimum 25 percent year-over-year earnings growth for the current quarter (Proj EPS %Change Cur Qtr), the current fiscal year, and the next fiscal year (Don’t enter the ‘%’ symbol).

To insure that the analysts’ expected earnings growth isn’t just a short-term phenomenon, require at least 25 percent forecast average annual growth over the next five years (Proj EPS Annualized 5-Yr). However, too much forecast growth signals extra risk. Research has found that companies with forecasted long-term annual earnings growth of 40 percent or higher rarely live up to those expectations. Their stock prices usually crash when the forecasts are reduced to more realistic levels. So, in addition to the 25 percent minimum, specify 35 percent for the maximum acceptable forecasted long-term earnings growth.

Out of the 6,000 or so U.S. listed stocks, only 34 met those earnings growth requirements.

Reduce Risk 
Next we’ll add additional search requirements to eliminate the riskiest candidates, starting with institutional ownership.

Institutional buyers such as mutual funds and pension plans employ squads of analysts to research stocks. So instead of reinventing the wheel, it makes sense to piggyback on their efforts and avoid stocks that the big boys are shunning.

Institutional ownership is the percentage of a firm’s outstanding shares owned by these big players. Institutional ownership typically ranges from 40 percent all the way up to 95 percent for in-favor stocks. Specify a minimum 40 percent institutional ownership (labeled institutional holdings).

Another way of avoiding risky stocks is to pay attention to short-sellers’ activity. Short sellers sell shares they’ve borrowed from a broker in the hopes that they can buy shares at a lower price later to replenish the shares that they’ve borrowed. They make money if the stock price drops during the time they are short and lose if the stock price moves up.

Short-sellers are usually expert at analyzing a firm’s fundamental outlook. Consequently, it pays to avoid stocks with heavy short selling.

Short interest is the number of shares that have been borrowed by short sellers for their trades. The short-interest ratio is the number of days it would take for the short sellers to buy back their borrowed shares, based on the recent average daily trading volume.

Short interest ratios run from zero to 20 days, and sometimes higher. The higher the ratio, the higher the short interest. Usually, growth stocks have ratios below five or six. Specify a maximum seven short-interest ratio to rule out stocks in the short-sellers’ crosshairs.

Not Buy & Hold 
My screen turned up a total of 22 stocks, too many to list here. Not surprisingly, considering energy prices, six of them were in the energy industry. As is the case with all screens, the results are research candidates, not a buy list. Another caveat, high-growth stocks are not long-term buy and holds. They must be watched closely and sold when anything goes wrong.
published 11/13/05

 

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