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Stocks of companies generating higher earnings growth than that of their sector average are called growth stocks. Although these stocks may be overpriced, they represent significant potential for capital appreciation. Since the company is delivering more or less supernormal growth, these stocks are also known as supernormal growth stocks.
Growth stocks could also refer to shares that have rapidly appreciated in value, delivering a higher return on equity (ROE = the company’s net income / the share price) than other stocks in the sector. A stock is categorized as a growth stock when it yields a minimum ROE of 15%. Sectors like information technology and telecommunications are most renowned forhigh-yield growth stocks.
The appreciation of growth stocks is typically sporadic and the ROE from such stocks eventually return to normal growth levels.
CANSLIM Method to Identify Growth Stocks
William O’Neill, an expert stockbroker gave the CANSLIM approach to identify growth stocks. It is explained as:
C = Current Earnings: The most recent quarterly earnings per share of growth stocks are within the range of 18% to 20%.
A = Annual Earnings: Growth shares deliver stable annual earnings over a span of five years. The five-year average earnings of a typical growth stock increase at a minimum rate of 10%.
N = New Things: Regular stocks transform into growth stocks when the issuing company witnesses a series of positive events.
S = Supply and Demand: Avoid investing in slow-growing large cap stocks. One can observe the index of demand of a stock by observing its trading volume.
L = Leaders: Over the course of a business cycle, the stocks of market leaders can become growth stocks. Buying laggards needs to be avoided.
I = Institutional Sponsorship: Stocks issued by companies that have the backing of institutional sponsors can become growth stocks.
M = General Market: Understanding the current direction of the market by making efforts to interpret daily general indices and the actions of market leaders helps in spotting growth stocks.
Before investing in growth stocks, investors should take into account that they are sold at inflated prices. They rarely offerdividends as their issuers usually reinvest profits to fund future projects. One has to be careful while opting for a growthstock, as such stocks are highly vulnerable to market swings.