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Growth stocks can pave the way for explosive returns, but not all of them live up to expectations. Fortunately, many of the duds, no matter how tempting, can be discounted by looking at three simple factors.
1. Visionary leadership
No matter how spectacular a business model may be, it often leads to nothing if the management team does not know how to unlock the underlying potential.
Having a visionary leader is an intangible asset that can be quite subjective to identify. Personally, I like to see serial entrepreneurs at the helm. In my opinion, individuals who have already achieved business success are usually good candidates. But above all, passion is a must.
That’s why I always enjoy seeing how the founders steer the ship. There are plenty of career managers who move from one company to another and earn a hefty salary in the process. But this can lead to short-term thinking to maximize compensation. And that is a direct conflict of interest between management and shareholders.
Research has shown that founder-led companies tend to outperform other types of companies. These individuals tend to be much more focused on the long term, receive more reasonable salaries, and tend to create a more personal workplace culture. Of course there are always exceptions.
2. Disruptive potential
Remaking similar products of higher quality can be lucrative. However, if I’m looking for massive growth opportunities, I want to see a company that can completely disrupt an entire sector or market.
Needless to say, these are few and far between. And disrupting an entire industry isn’t easy, especially when you’re up against big companies that have far more resources to fight back. But in rare cases, having all the money in the world won’t be enough to prevent a new innovation that outperforms in every respect.
The battle between Netflix and Blockbuster is a perfect example of that. Just as Amazon changing the way consumers shopped twenty years ago.
3. Protected by a growing moat
Even if a company successfully disrupts an industry, the story is not over. Competitors may adapt, or new startups may emerge to capitalize in the aftermath. This is where having increasingly powerful competitive advantages is critical.
Forging an advantage that can be used against competitors is the ultimate strategy for stealing market share. And by ensuring that such benefits cannot be replicated, these newly acquired customers are less likely to be poached later.
One of the best competitive advantages I think a company can have is something called a network effect. And it is also one of the most difficult to make.
This is when a product or service becomes more valuable as more people use it. In the 1990s, Microsoft had perhaps one of the largest network effects in the world with its Office Suite software. Although it took years, the company managed to get millions of people using the Word and Excel programs, eventually making it a global standard.
It’s rare to come across a company with these three qualities. And while this is far from the end of the analysis, in my opinion many mediocre growth stocks can be avoided.
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