Growth stocks can pave the way for explosive returns, but not all live up to expectations. Fortunately, a lot of the duds, however tempting, can be eliminated from consideration by looking at three simple factors.
1. Visionary leadership
Regardless of how spectacular a business model may be, it often ends up going nowhere if the management team don’t know how to unlock the underlying potential.
Having a visionary leader is an intangible asset that can be fairly subjective to identify. Personally, I like seeing serial entrepreneurs at the helm. In my eyes, Individuals who have already achieved business success are usually good candidates. However, above all else, passion is a must.
This is why I always like seeing founders steer the ship. There are plenty of career executives who move from one company to the next, earning a chunky paycheck in the process. But this can lead to short-term thinking to maximise compensation. And that’s a direct conflict of interest between management and shareholders.
Studies have shown that founder-led companies typically outperform other types of businesses. These individuals are typically far more focused on the long run, take more reasonable salaries, and usually create a more personal workplace culture. Of course, there are always exceptions.
2. Disruptive potential
Re-creating similar products of a higher quality can be lucrative. However, when looking for monster growth opportunities, I want to see a business that can completely disrupt an entire industry or market.
Needless to say, these are few and far between. And disrupting an entire sector is hardly straightforward, especially when going up against corporate titans with far more resources to fight back. But in rare cases, having all the money in the world won’t be enough to prevent a new innovation that outperforms in every aspect.
The battle between Netflix and Blockbuster serves as a perfect example of this. As does Amazon changing the way consumers did their shopping 20 years ago.
3. Protected by a growing moat
Even if a company successfully disrupts an industry, the story is not over. Competitors may adapt, or new start-ups can emerge to capitalise in the aftermath. This is where having increasingly potent competitive advantages is critical.
Forging an edge that can be used against competitors is the ultimate strategy for stealing market share. And by ensuring such advantages can’t be replicated, these newly-acquired customers are less likely to be later poached.
One of the best competitive advantages that I believe a company can have is something called a Network Effect. And it’s also one of the hardest to create.
This is when a product or service becomes more valuable the more people use it. In the 1990s, Microsoft had arguably one of the biggest network effects in the world with its Office Suite of software. Though it took years, the company managed to get millions of people using its Word and Excel programmes, eventually becoming a global standard.
Stumbling upon a business with these three traits is rare. And while this is far from the end of the analysis, a lot of mediocre growth stocks can be avoided, in my opinion.
