Picking High-Growth Companies: How to Find the Next Apple
by Alexander Green, Investment U Chief Investment Strategist
Friday, February 17, 2012: Issue #1711

Apple’s share price exceeded $500 this week, giving it the largest market cap of any U.S. company.

Apple (Nasdaq: AAPL) so successfully sells computers, phones and other electronic gadgets that recently announced fourth-quarter profits soared 118% on a 73% increase in revenue. This is unheard of for a $475-billion company.

To put this in perspective, earnings at the companies in the S&P 500 stock index are on track to post a 6.6% year-on-year rise for the fourth quarter. Yet once Apple’s earnings are factored out, the expected fourth-quarter gain shrivels to just 2.8%. This so skews results that many Wall Street analysts are now stripping Apple from the index before weighing valuations and making forecasts.

Of course, it’s just a matter of time before Apple’s torrid growth begins to wane. It’s not possible for $500-billion companies to keep growing at the rate of $5-billion companies… or even $50-billion companies.

So the key is to search for the next Apple. But how do you find it?

Fortunately, the factors that make a great-performing stock are well known and have been intensively studied by academics and researchers. We know the key characteristics that top-performing stocks generally possess before making their parabolic moves up.

Here are just a few:

  1. Double-digit sales growth. You can only grow the bottom line for so long by cutting costs. Every business needs to have healthy top-line growth before it can generate robust and sustainable long-term earnings growth. Note that sales at Apple jumped 73% last quarter.
  2. At least 25% quarterly earnings growth. In an economy as weak as this one, most companies can’t meet these first two hurdles. But, again, Apple is seeing earnings growth at more than four times this rate.
  3. A return on equity of 17% or more. Return on equity – an excellent measure of management’s efficiency with capital – is calculated by dividing earnings per share by book value per share. (This is one of Warren Buffett’s key metrics, too.) Note that Apple’s return on equity is a whopping 46%.
  4. New products and services. Apple is the king of innovation, regularly bringing out not just new versions of products but entirely new products: iPods, iTunes, iPhones and iPads.
  5. High-quality management. Never forget that every company is essentially a team of people. And just as every great sports franchise needs a highly qualified coach, so does each company require a visionary leader. Apple’s co-founder and former CEO Steve Jobs was one of the greats. Now that he’s gone, it will be interesting to see how the new management performs.
  6. Institutional support. The vast majority of shares traded on the major exchanges are mutual funds, hedge funds, pension plans and endowments. You want to own the same stocks the institutions are buying. And, indeed, institutions own more than 70% of Apple’s outstanding shares.

These are some of the key criteria that companies need to meet to generate superior long-term returns for shareholders.

We may not see another company in our lifetimes that transforms the business landscape the way Apple has. But there are plenty of great innovators out there, including Amazon (Nasdaq: AMZN), Google (Nasdaq: GOOG), Genentech, eBay (Nasdaq: EBAY), Costco (Nasdaq: COST) and Intuitive Surgical (Nasdaq: ISRG).

These companies – and others like them – are likely to be among the best-performing stocks in the years ahead.

Good Investing,

Alexander Green