Growth stocks are much in demand, and are especially attractive to the investor who is more interested in capital gains than income.
What is a growth company? As the term is used by most analysts, it applies to a company that is expected to show sales and earnings continuously increasing at a much faster rate than the advance in the economy as a whole. Many growth trends are volatile, so that it is not always apparent just which stock is in a true growth situation and which is merely a flash in the pan. There is some argument as to whether growth is based upon research alone, since a number of growth examples show a steady increase in earnings and also in the equity per share, without extensive research programs. It is true that many of the present-day growth companies, as exemplified by the chemicals, have far-reaching research programs; but it is equally true that some other growth companies have lacked well-organized research.
Nevertheless, we may recognize a growth situation by several of the following characteristics: continuous increase in earnings; continuous increase in net worth per share; developmental advances in a product or process; the plowing back of a considerable portion of earnings into the business, with correspondingly few or even no dividends; an industry with excellent sales and earnings prospects; a dynamic research program; an outstanding management, with much technical know-how in the development of new products and processes, coupled with the ability to attract younger men who possess energy, ability, and resourcefulness.
Before selecting a growth situation the investor must realize that he may be assuming considerable risk. For every Minnesota Mining and Manufacturing, there are perhaps a hundred others, which fail to make the grade and become mediocre; for every Food Machinery and Chemical or Dow Chemical, there will be a hundred others that drift into the class of unsuccessful or even failure enterprises. The best plan might be to follow the leaders in financial circles and purchase only those whose growth characteristics are already recognized; otherwise a high degree of speculative risk will attach to the choice of the small company which has a "new process" or "unusual product" as yet untried. Very often stock in such companies is attractive because it is cheap; but even cheapness is no recommendation for extreme speculation. A list of some of the currently recognized "growth situations" may be obtained from a broker.
Still another reason for a high price-earnings ratio is to be found in those companies which do the exploration work for mineral wealth, such as petroleum, copper, rare metals, etc. Investors are willing to pay more for them, because mineral reserves will probably prove more valuable in the future and are considered to be quite conservatively valued today; indeed, the costs of prospecting and extraction of mineral wealth have steadily increased with time.
Perhaps we may include some word of warning at this point and suggest that an exceedingly low price-earnings ratio will convey a caution signal to the investor. Why should a P: E as low as 8 occur?
Such a low figure may indicate several things: the stock is very under priced; the industry group represented is at the moment in disfavor; prospects for the stock are mediocre because of continued poor or erratic earnings; the industry represented is a segment of the economy which is neglected because of more "glamour" attached to other segments; the industry or stock is enjoying only temporary prosperity; the industry is subject to wide swings in earnings. At any rate, be careful!
For every potential gold-mine return, the investor must remember that there is an equal if not greater risk of disasterous loss. It is advisable, then, to take into account your mental state (and blood pressure) before investing in growth stocks that could take you to the cleaners before you take them to the bank.