Investing in the right growth shares early on, like Amazon or Tesla, can turn out to be hugely rewarding. But a lot of companies that seem to dangle promising prospects burn cash and peter out.
When selecting growth shares for my portfolio, here are three things I usually look for.
Plenty of potential customers
Tech firms often talk about their ‘total addressable market’. That term basically means how big is the market size a company is targeting?
The answer can be confusing. Take drinks maker Diageo for example. Is its addressable market premium alcohol drinkers? Or is it the larger market of any alcohol drinkers? Or, with non-alcoholic brands such as Seedlip in its portfolio, is it just anyone who ever drinks anything?
Figuring out a company’s target market can be harder than it looks. But to do well, a business needs either a big pool of potential customers, or a smaller pool of wealthy potential customers. Consider Bank of Georgia as an example. Its shares have more than doubled in the past year.
Can the growth share continue such a run for years or decades to come? Its operations are concentrated in Georgia, which has less than half the population of central London. Without significant overseas expansion, I see that as a limiter on the bank’s growth opportunities.
Meaningful competitive advantage
One thing the Bank of Georgia does have going for it is what Warren Buffett calls a ‘moat’. That is a competitive advantage that helps a business do well even in a crowded marketplace.
A moat is something I look for when choosing growth shares for my portfolio. It could be the existing customer base of a company in an industry with high switching costs, like banking. It might be the brand and technology of a company like Apple, Buffett’s largest holding. Or it may be some proprietary technology, something common among biotech shares for example.
Show me the money!
Despite that, I rarely invest in biotech shares. Why? Many have a large target market and a competitive advantage in the form of patented technology. But what they often lack is a proven business model that is generating rather than consuming cash.
This is where I part company with some other investors when it comes to choosing growth shares. Many people reckon that, if a company is developing new technology or markets, it is unrealistic to expect it to be profitable at the same time. By investing early, they hope to do well later.
Usually, I would rather wait and see how a business performs, even if it means that I do not get in early. I may pay more for growth shares that way, but the flipside is that I am investing in companies that have already proven some level of commercial performance.
Having a competitive advantage in a large market does not automatically translate into profits. That takes things such as sales capability, distribution networks, supplier relationships and more.
Many companies with promising technology or some other potential moat fall at this hurdle. Finding businesses that have already succeeded commercially to some extent and still have bags of potential is what I look for.
The post Brilliant growth shares often have these three characteristics appeared first on The Motley Fool UK.
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John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. C Ruane has no position in any of the shares mentioned. The Motley Fool UK has recommended Amazon.com, Apple, Diageo Plc, and Tesla. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
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