Little Known Growth Strategy With Big Returns

Think "small growth stocks", and you probably think of flashy, exciting stocks that may generate high returns -- but not without a lot of risk and a lot of volatility.

But it doesn't have to be that way. My "Guru Strategies" -- investment models picked using the approaches of such great investors as Warren Buffett, Benjamin Graham, and Peter Lynch -- run the gamut from large value strategies to small growth strategies to hybrid growth/value models. And, since I started tracking them nearly eight years ago, the best performer of all has been a small growth approach -- and it's one that's also been remarkably consistent and only slightly more volatile than the broader market.

The approach: my Motley Fool-based model, which is based on the strategy that brothers and Motley Fool creators Tom and David Gardner laid out in their 1996 book The Motley Fool Investment Guide: How the Fool Beats Wall Street's Wise Men and How You Can Too. Since I started tracking it in July 2003, a 10-stock portfolio picked using the method has gained 224.3% (through May 15). That's 16.2% annualized during a period in which the S&P 500 has averaged annual gains of just 3.7%.

What's more, while even the best strategies will have years in which they lag the broader market, the Fool-based portfolio has yet to do so -- it's the only one of my portfolios that can make such a claim. It's beaten the S&P by at least 6.4 percentage points every year. In addition to significantly outperforming the market during bullish periods, it has also fared well when times have been tough. In 2007 and 2008, while the S&P was losing a total of 37.3%, the Fool portfolio lost just 7.5%. Plus, it's generated its strong returns with a beta of just 1.1, meaning it's been only slightly more volatile than the broader market.

A Comprehensive Growth Approach

How has the approach fared so well? By being thorough -- very thorough. While all of my models look at a variety of variables, the Fool-based strategy looks at the more than any of them, examining about 17 different criteria.

And those variables run the gamut. Some, like 12-month relative strength (which should be at least 90), look at price and momentum. But most examine the stock's underlying business, making sure that a strong and improving business is supporting the stock's performance. After-tax profit margins should be at least 7% in the most recent year, for example, and margins should be consistent or rising over the past three years. Recent earnings and sales growth must also be strong, with both net income and revenue rising at least 25% in the most recent quarter.

The Fool-based model is also big on cash. It likes to see a positive free cash flow per share, and it doesn't like debt -- a firm's long-term debt/equity ratio should be no higher than 5%. Other areas it looks at include the accounts receivable/sales ratio, income tax levels, and research and development budgets.

While it's a growth model, the Fool-based model includes a key valuation metric: the "Fool Ratio", which is essentially the P/E/Growth ratio that Peter Lynch made famous. This ideally should be no greater than 0.5, though it can be slightly higher if the firm's other fundamentals are excellent.

While it doesn't have a market cap criterion, the Fool-inspired portfolio tends to focus on smaller stocks. That's because it keys on firms with less than $500 million in annual sales, daily dollar volumes no greater than $25 million, and prices below $20 a share, since those are the companies that tend to fly under the radar.

Hard to Please

When you put all of this together, you get a rigorous growth strategy that is not easily impressed. Right now, only two stocks get "strong interest" (scores of 90% or above) from the Fool-based model. Here's a look at those two, along with a few others that get very solid scores in the 80%-90% range:

MercadoLibre, Inc. (MELI): This Argentina-based online commerce platform is Latin America's version of eBay, with major presences in Argentina, Brazil, Chile, Colombia, Venezuela, Mexico, and several other countries.

MercadoLibre is currently my Fool-based model's favorite stock in the entire U.S. market, earning a 96% score. It isn't a small-cap ($3.9 billion), but its $232.2 million in annual sales puts it on my Fool-based model's radar. The strategy likes the firm's excellent recent growth -- last quarter it upped EPS by 45.5% and sales by 33.8%. The market has taken notice; since late November 2008, MeracadoLibre's shares have risen more than 10-fold, and it has a relative strength of 91.

A few more reasons the Fool-based approach likes MercadoLibre: Its profit margins are high and increasing (13.7%, 19.2%, and 25.9% over the past three years); it's conservatively financed, with a debt/equity ratio of just 0.09%; it's producing $1.23 in free cash flow per share; and it's shares are attractively priced, with a P/E/G ratio of 0.43.

lululemon athletica inc. (LULU): Vancouver-based lululemon ($5.1 billion market cap) makes athletic clothing, focusing on apparel for yoga, running, and dancing. My Fool-based portfolio picked up its shares back in late November 2009, and since then, the stock has surged more than 270%.

The strategy thinks it has more room to run. The stock currently gets a 92% score from the approach, thanks in part to the firm's strong recent growth (it upped EPS 90% and sales 53% in its last quarter) and increasing profit margins (11.1%, 12.9%, and 17.1% over the past three years). The strategy also likes that the stock has plenty of momentum behind it, with a relative strength of 96, and that it has no long-term debt and a P/E/G ratio of 0.6.

Amtech Systems, Inc. ( ASYS ): Based in Tempe, Ariz., Amtech makes capital equipment used in fabricating solar cells and semiconductor devices. It's a small-cap ($209 million), and it's really turned things around in the past year. Its trailing 12-month EPS are $2.28; in the previous 12 months, they were -$0.02. Sales for the past 12 months, meanwhile, have more than tripled vs. the prior 12 months.

That strong recent growth is one reason the Fool-based model likes Amtech, which earns an 87% score from the approach. It also likes its 96 relative strength, its 10.7% after-tax profit margin, lack of any long-term debt, and 0.31 P/E/G ratio.

MarketAxess Holdings Inc. (MKTX): This New York City-based firm operates an electronic trading platform that lets investment professionals trade corporate bonds and other fixed-income instruments. It has a market cap just under $800 million.

The Fool-based approach gives MarketAxess an 87% score. It likes its strong recent growth (EPS rose 59% and sales rose 25% last quarter), and the firm's high and increasing profit margins (8.5%, 14.1%, and 21.5% over the past three years). It also likes its positive free cash flow ($1.19 per share) and reasonable 0.6 P/E/G ratio.

One of MarketAxess' only flaws according to this model is that its relative strength isn't high enough, though at 74 it's not bad.

First Cash Financial Services ( FCFS ): Texas-based First Cash ($1.2 billion market cap) operates pawn stores and cash advance stores. It stands to reason that pawn stores would do well when the economy is struggling, and First Cash fared quite well throughout the Great Recession. But its strong track record goes back much further -- the firm has actually upped EPS in each year of the past decade.

First Cash gets an 87% score from the Fool-based model, which likes its 13.1% profit margins and strong recent growth (it upped EPS 51.5% and sales 27.7% in the first quarter). It also likes the First Cash's 91 relative strength, and tiny 0.4% debt/equity ratio. One of the only blemishes on the stock is that it's not dirt cheap, selling for a P/E/G of 0.91. Still, that's not all that expensive for a fast-growing, fundamentally sound stock.

I'm long MELI, LULU, ASYS, and MKTX.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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