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Commentary

The dos and don'ts of growth investing

Britain's decision to leave the European Union came as a shock to many people. It even surprised those who were campaigning for Brexit. So great was the disbelief that stock markets around the world buckled at the knees, briefly. But canny investors took advantage of the fall to add to their holdings.

Mr Peter Lynch, one of the best growth investors of our time, said: "Develop a disciplined approach to investing that enables us to block out our own distress signals." The key to successful investing is to have a plan. So whether you are a growth investor or an income investor, it is important to block out market noise, regardless of how loud the din might be.

This month's article will focus on the disciplines that make for successful growth investing. It is my dos and don'ts of effective growth investing. Please do not tune out just because you are an income investor. You should find a lot of things that apply to you, even if your preference is for dividend cheques rather than capital growth.

DO LOOK AT CASH FLOW

Cash is a company's lifeblood. If it stops flowing, the company dies. A lot of investors focus on earnings, but earnings can be easily massaged. It might not accurately reflect the strength of a company's operations. Cash flow, while still not perfect, provides us with a better picture of a company's health.


Demonstrators campaigning on both sides of the Brexit issue, which resulted in world markets tumbling briefly when Britain voted to leave the EU. However, it is important to block out market noise, regardless of how loud the din might be, when one is investing. PHOTO: AGENCE FRANCE-PRESSE

DON'T IGNORE THE BALANCE SHEET

If we think of cash flow as a sphygmomanometer reading, then the balance sheet is the annual health report. The world is a tricky place and even the best business plan can run into problems. A company with a strong balance sheet can better handle many of life's surprises and get back on its feet. Heavily indebted companies have much less flexibility. They can be dragged down if times get tough.

DO LOOK FOR INNOVATION

While large companies have the advantages of brand name recognition, strong balance sheets and industry leadership positions, they can also be bloated bureaucracies slow to respond to a changing competitive landscape.

Small companies, led by visionary management, are able to create new technologies and products quickly. Even if a company just moves from doing mediocre business today to fair business tomorrow, you could do well.

DON'T RELY ON PAST PERFORMANCE

Few things in this world are guaranteed. So, three successive years of 30 per cent earnings growth is unlikely to be repeated, if only because it gets harder to grow as one gets bigger.

Additionally, profit margins above 20 per cent are very difficult to sustain with competition and inflation snapping at one's heels. We need to recognise that we are buying into a company's future and to evaluate the shares accordingly.

DO CONTROL YOUR EMOTIONS

We are our own worst enemies because of our tendency to make emotional decisions instead of rational ones. This leads us to be scared of owning shares when they are falling, even though that is often the best time to buy.

DON'T OVERPAY

The fastest way to turn a phenomenal company into a terrible investment is to get swept up in the excitement of a rapidly rising share price and pay more for the shares than the business could ever be worth.

DON'T GET INTO BUYING SPREES

Make a watch list of companies and sooner or later, we are likely to get a great buying opportunity on every one of them.

DO CONSIDER MARKET POTENTIAL

It is easy to get sucked into a great growth story. But we want to be sure we are not being sold a pup. A company's growth potential is ultimately determined by the limiting size of its end market. So investors need to get a grasp of a company's end market and how much room there is left to run.

DON'T FORGET WHY WE BUY SHARES

We should have clear reasons for investing in a company. So, set up clear signposts for evaluating the company's performance.

Writing these down at the time of purchase can make holding shares simpler when the market is volatile. It can help us block the noise of day-to-day market movements and focus on the long term.

It also makes selling decisions easier. If a company isn't living up to our expectations, it may be time to leave something for the next investor.

Investors often blame the market when things go wrong. But stock markets and companies don't determine our fate. It is how we behave, when the market tests our resolve, that counts. With a clear investing plan, we should be much better prepared.

•This is a regular monthly column on stocks and investing by Mr David Kuo, chief executive officer of The Motley Fool Singapore.

A version of this article appeared in the print edition of The Straits Times on July 25, 2016, with the headline 'The dos and don'ts of growth investing'. Print Edition | Subscribe