How to Spot the Next Multi-Bagger; 5 Traits of Great Growth Stocks

Robert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Great growth stocks typically exhibit five traits:

  1. New Business: A revolutionary product or business model that’s taking the marketplace by force.
  2. Wide Moat: A sustainable, competitive advantage that protects the company from rivals.
  3. Earnings and Price Momentum: Ability to deliver double digit earnings and revenue growth; regular member on the 52-week high list.
  4. Excellent Management: Visionary leadership with the skills needed to execute the company’s growth strategy.
  5. Public Controversy: Evidence the public thinks the stock is too expensive. Big winners often continue even after Wall Street has declared you missed your chance to buy.

Let's take a look at three growth stocks that best illustrate all five of these traits. (NASDAQ: AMZN) is in the process of reshaping the retail landscape with its enormously successful on-line business model.

Amazon's sheer size means it can also negotiate low prices from suppliers becoming the low cost price leader. The company has also invested heavily in its distribution system to provide customers same-day delivery making Amazon a direct threat to every brick-and-mortar business. This scale represents a huge competitive advantage, which can be exploited for years to come.

In addition to the company’s core e-commerce business, Amazon also expanded into cloud computing, business supplies, tablets, and digital content. Together, Amazon could grow sales at a 30% clip over the next four years, based on a research report by Morgan Stanley. By 2016, the report predicts, Amazon could gross $166 billion, almost triple current revenues.

Yet Amazon continues to boggle its critics. Shares of the world’s largest e-tailer are up 45% in the past year despite a four-digit P/E multiple and thin operating margins.

Here's what the bears are missing: Jeff Bezos isn't managing Amazon to appease Wall Street analysts next quarter, but to build a behemoth for world retail domination. Profits and margins will begin to improve when the company ends its expensive investment program. 

Lululemon Athletica

Lululemon (NASDAQ: LULU) has taken over women’s fitness apparel by developing a cult-like following around its products. Despite cheaper alternatives, customers are willing to pay a premium for the company's brand name, allowing Lululemon to earn the highest gross margins in the apparel industry. This is clear evidence of the company's pricing power.

Lululemon has a massive expansion runway with analysts projecting the company to post 25% EPS growth over the next five years driven by four factors:

  1. Domestic Growth: Assuming Lululemon can penetrate the American market to the same degree it has in Canada, the company has room to almost triple its U.S. store count from 127 to 300 locations. 
  2. International Expansion: With only 4% of sales are derived from outside North America, Lululemon has lots of room for international expansion. The company has a foothold in Australia, New Zealand and the U.K. with Asia and Europe remaining completely untapped.
  3. New Product Lines: Lululemon is targeting new demographics by including men’s apparel, children’s clothing and road cycling equipment. 
  4. e-Commerce: During the previous third quarter, online sales grew 90% year over year, and accounted for only 14% of Lululemon's revenues.

Can Lulu's management execute this aggressive growth plan? CEO Christine Day has a track record of leading successful expansion campaigns. Before taking over Lululemon in 2008, Day was in charge of Starbucks' Asian division. 

Once again, skeptics are concerned about the stock’s premium valuation. Shares are trading around 30 times forward earnings, the highest multiple in the apparel space. But given the company’s 25% growth rate, the stock trades at a reasonable 1.2 PEG ratio, in line with industry peers. (NYSE: CRM) has come to dominate cloud computing. The company's suite of applications allows customers to better organize their sales operations and drive revenue. By using a cloud platform, businesses can implement’s applications cheaper and quicker than competitors. The formula is working. Over the past five years, the company has manged to post an impressive 30% annual top and bottom line growth. 

The cloud computing story is still developing, with the industry expected to grow 25% annually over the next seven years. With leveraged to the holy trinity of tech trends -- cloud, mobile, and social -- industry tailwinds will allow the company to post double-digit earnings growth through 2020.

Yet in spite of strong fundamentals, no other company draws more comparisons to the tech bubble excesses of 1999 than, with its stock trading at 85 times forward profits. Critics point to competitors like SAP or Oracle, which trade at 21 and 12 times earnings, respectively. 

The issue with this analysis is that these companies don’t make suitable comparisons. It’s more appropriate to compare to another cloud name like Rackspace, which trades at similar 75-times forward multiple. However, deserves its premium, thanks to its higher projected earnings growth rate.

Foolish Bottom Line

All three of these companies represent the characteristics of great growth stocks due to their strong earnings momentum, sustainable competitive advantages, and excellent management teams.

But here's the key takeaway: Don’t dismiss a stock outright because of a high P/E multiple or a recent price gains. Many of the greatest growth stocks in history like Wal-Mart, McDonald's and Coca Cola all sported expensive valuations during their multi-decade runs. Yet each of these companies created fortunes for investors. 

RobertBaillieul has no position in any stocks mentioned. The Motley Fool recommends, Lululemon Athletica, and The Motley Fool owns shares of Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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