Today I'd like to share my three-step approach for beginning to build a growth portfolio. I think many readers who see the 275-per-cent gain in my Strategy Lab model growth portfolio over the past three years wonder how they can achieve the same thing. At least that's the impression I get from the e-mails people have sent in.
I'm the first to admit that the technology sector I focus on was particularly undervalued at the time we started the Strategy Lab portfolios, and I didn't expect to produce such impressive returns. But I built the portfolio with long-term thinking in mind, and if I had to start over, I'd still include all of the same names. Since I'm not about to start coaching individuals on investing, despite many requests, I thought I could instead discuss how you might go about building your own growth portfolio.
Keep in mind that when I say "growth portfolio" I'm referring to the portion of your already-diversified investments that you allocate to higher-growth, higher-volatility stocks. My advice may lead you to own many of the same stocks I hold in my model portfolio, but depending on your interests, knowledge and personal views about the future, it may lead you to hold very different stocks.
Step one is to pick stocks that genuinely excite you. In the past I've said that I pick stocks by looking for leaders in important, emerging industries that will radically change the old way of doing something. Three classic examples are Netflix for how we watch TV, Facebook for interacting online with others, and Tesla for building electric cars and driving us toward a sustainable source of fuel for transportation. There are likely thousands of other examples to choose from, but my interests and knowledge of niche markets has a limit, as does yours. Focus on what excites you.
As a test, I suggest you ask yourself if a potential company that you're considering investing in is making a real difference within its industry. If your answer is anything less than "Hell yes!", start over. Find another stock. Build up a growth portfolio around a small number of stocks you are interested in following because they excite you. Stocks that aren't changing their industries aren't usually very exciting.
Step two is to think about the long-term potential and what it means to valuation. Exciting stocks are nice, but there needs to be a long-term business case you can wrap your head around. You need to be able to logically consider what's possible over the next decade or so. Then, decide what kind of revenue, gross margin and profit is possible under a few different success scenarios. I'll often consider what the company could be worth if it traded at 15 to 20 times earnings for pessimistic and optimistic growth scenarios. If I think a stock may grow only two to threefold under very optimistic conditions, I'm probably not a buyer. But if I think the stock may be worth several times its current price with only moderate success, then I'm keeping the stock on my short list.
The third and final step is to get deeper into the details. When I research a stock, my aim is to be more knowledgeable about the business than the vast majority of people who might ever ask me about it. I want to feel as if I have expert knowledge of the business. While I'm doing this I'm also on the lookout for the best, most logical bear arguments that I can find. If I have strong company and industry knowledge and the bear thesis doesn't crush my interest in the stock, I'm probably a buyer.
Unless you dedicate sufficient time to do deep learning about a company and industry, you'll never develop enough knowledge to feel like an expert. That's why you must start with stocks that excite you. When the topic is exciting the research never feels like work. There are better things to do with your time than spend hours upon hours reading financial reports and listening to conference calls that bore you.
Growth investing should be profitable and enjoyable. If it's not exciting, don't do it. Simply invest your time in something else, and invest your money in index funds.