The Truest Way to Measure Growth

You have to sell something in order to grow.

It may sound ridiculous, but one of the most important factors for a small cap growth stock is that it is actually growing sales. Simple, but true. After some of the accounting and earnings management scandals over the past decade the comment becomes less absurd.

***The truest way to measure real growth is to identify whether the company is selling more - and how much more - on a year-over-year basis. Dollars can be maneuvered around the income statement to massage earnings, but it is very difficult to massage top-line revenue. Sales growth is a key metric for my stock picking. I look for revenue increases of at least 20 percent year-over-year.

Over the years as I go through and test each of the metrics I use to pick small cap stocks I continually find that sales growth is one of the most powerful metrics I use. I have found that without rapid quarter-over-quarter or year-over-tear sales growth it is nearly impossible for a small cap company to achieve the results I seek. According to Morningstar, small cap companies in the top 5 percent of sales growth outperform those in the bottom 5 percent by over 50 percent.

***There are basically two ways for a company to achieve faster growth. The first way is for a company to have a product or service that is simply so popular and in demand that more of it will sell each and every quarter. Take Lululemon (Nasdaq: LULU). In four years, sales went from $148.0 million to $452.9 million as the market for yoga-related products became more popular. Whenever a company is growing sales by 30 to 80 percent year-over-year good things are likely to occur to the stock price.

The second leading cause of rapid sales growth arises in companies where the supply/demand imbalance creates steady price increases. In other words, prices and demand rise but the costs of doing business do not go up that much. For example, take small cap silver mining company First Majestic Silver (NYSE: AG; FR.TO). As silver prices skyrocketed over the past two years revenues have doubled for the small Canadian miner. The rapid revenue increase for First Majestic led to over 100 percent gains over the last two years.

Although I am very much a bottom-up stock picker, I often find that increased demand for a particular product or service may lead companies in the same industry to show up on my watchlist. In other words, the entire industry group benefits from strong sales growth.

Accelerating revenues have been a hallmark of just about every tremendous winner I have had in my career. Companies that show lasting growth in sales are going to produce returns that are not dependent on the overall market or economy. They are in their own little world of price appreciation, which is exactly what an investor should seek.

***Slowing sales growth is one of the fastest ways to get kicked out my watchlist. There are times when even great companies are going to find it difficult to sustain sales growth. They may even succeed themselves out of success. Cisco and Intel are great examples of being undone by success. Both companies were once tech-darlings with fast growing revenues that revolutionized the world of technology and made vast computing power accessible to individuals on an unprecedented scale.

However, both companies became so completely dominate in their respective industries that their opportunity for rapid sales growth diminished. Both firms now have to grow sales through product upgrades or acquisitions and will likely never see the type of skyrocketing growth they once enjoyed.

So as you can see, it is very important to watch carefully for declining sales growth. Because it is such a strong metric in selecting small cap stocks, slowing sales is a real danger sign for me.

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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