10 great growth stocks at the right price

Growth shares have produced spectacular results across the market over the past year. We've seen triple-digit percentage gains in small-caps like Gear4Music and IQE through to larger plays like Boohoo.Com, Purplebricks and Fever-Tree. But what is it about these companies that the market adores, and what should you look for in growth stocks right now?

Part of the answer lies in the views of Peter Lynch, a legendary American fund manager. In the 13 years to 1990 he guided Fidelity's Magellan fund to an average 29.2% annual return. And he did it by focusing his attention on company earnings.

In his book, One Up on Wall Street, Lynch wrote: "If you can follow only one bit of data, follow the earnings... I subscribe to the crusty notion that sooner or later earnings make or break an investment in equities."

Lynch was far from alone in his assessment of the importance of earnings. Profit growth - particularly cash-backed profit growth - is a guiding principle for many of the UK's most successful investors and fund managers. You can count among them the likes of Dan Nickols, who runs the Old Mutual Smaller Companies fund, and Paul Marriage who runs the Schroder UK Dynamic Smaller Companies fund.

But after a prolonged run for a number of increasingly popular growth stocks, investors now face having to pay much higher prices to own them. With that in mind, it's worth a refresher on a strategy that we've covered before in this column - Growth at a Reasonable price (or GARP).

As the name suggests, GARP is a favoured approach of growth investors who balk at the prospect of overpaying. Combining earnings growth with other factors is one way of managing the risk of buying an overpriced growth stock that may well crash if sentiment suddenly turns against it.

So what does a GARP strategy look for?

First, like all growth investing models, a GARP strategy will look at a company's past profitability and the expectation that its earnings will keep growing. That means looking at earnings growth over the past three and five years. Likewise, sales growth and even dividend growth can be a pointer to firms that are growing at a clip.

Second, it's fair to say that 'reasonable price' is a subjective issue. In general, it means assessing the market's attitude to a stock; how it's valuing the growth and pricing its earnings and profitability outlook. Racy price-to-earnings (PE) multiples can be a pointer to stretched prices, which can be a risk if things go wrong.

A third component of GARP strategies is price momentum. Growth investors almost always look for stocks that have already caught the imagination of the market. Relative price strength - the performance of a share relative to the performance of the market - can be a useful indicator of shares that are outpacing the market even in bullish conditions.

On the hunt for GARP shares

To get an idea of companies currently showing strong growth characteristics, we've picked out a GARP strategy tracked by Stockopedia and presented some of the companies currently passing the strategy rules. A version of this strategy has seen an impressive 85.8% return over the past year. Again, it looks for above-average earnings growth, below-average valuations and positive price strength.

These rules produce a varied mix of stocks. In terms of price performance, they are led by the online marketing company, XLMedia, which appears to be a very profitable, fast growing business. Small-cap recruitment firms Staffline and Robert Walters also make the list, alongside much larger stocks like BA-owner International Consolidated Airlines and the housebuilders, Bellway and Persimmon.

Other fast growers include Jupiter Fund Management, the engineering contractor Renew, along with Photo-Me International and Avon Rubber.

Growth stocks tread a fine line

There is no doubt that growth stocks have been in a sweet spot over the past year. Rapid earnings growth, particularly in smaller companies, has resulted in some stunning re-ratings that have rewarded investors handsomely.

But it's worth remembering that these increasingly popular shares are prone to sharp de-ratings. When the market has high expectations, these shares can be savaged simply for performing in line with forecasts, rather than beating them. GARP strategies offer a form of protection from some of the most expensive growth in the market. In bullish but unpredictable conditions, keeping an eye on valuations could spare some costly disasters.

About Stockopedia

Interactive Investor's Stock Screening series is written by Ben Hobson of Stockopedia.com, the rules-based stockmarket investing website. You can click here to read Richard Beddard's review of Stockopedia.com and learn more about the site.

Interactive Investor readers can enjoy a completely FREE 14-day trial of Stockopedia by clicking here.

It's worth remembering that these and other investment articles on Interactive Investor are simply for generating ideas and if you are thinking of investing they should only ever be a starting point for your own in-depth research before making a decision.

*No fee for publication is involved between Interactive Investor and Stockopedia for this column.

Ben Hobson is Investment Strategies Editor at Stockopedia.com. His background is in business analysis and journalism. Ben researches and writes regularly on investment strategy performance and screening ideas for Stockopedia.com. He is the author of several ebooks including "How to Make Money in Value Stocks" and "The Smart Money Playbook"

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified