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How to Spot, and Profit from, Early-Stage Growth Stocks

Not every great trading system is truly “great.” It often depends on an investor’s willingness to follow their own self-imposed rules and to avoid pulling the trigger at inopportune times. Over the years I’ve developed a system for identifying early-stage growth stocks for (relatively) aggressive and engaged investors.

It’s not for the buy and hold crowd as much as it’s for the investor that wants to find the diamond in the rough and isn’t afraid to do a little digging to make sure opportunities are legit.

Here are eight of the most important parts of the system I’ve come up with.

8 Steps to Profit from Early-Stage Stocks
Find Big Ideas That are Part of Big Trends
There are a zillion trends out there that seem good. But it’s the really big and durable trends that you need exposure to for long-term wealth. Current examples include cloud computing, and the chip and data infrastructure needed to make it work, and personalized health care. Really big trends are so big there’s many ways to play them. That translates into lots of stocks, M&A potential and flexibility for investors to be right on the trend, but wrong on the occasional stock, and still make money.

Look for Revenue Growth Above 20%
Growth is a must-have for a young company, and the more the better. Beyond the obvious that revenue growth shows demand for products and solutions, these types of companies are sure to raise capital through equity raises and convertible debt offerings to fuel their growth. The pace of that growth needs to be great enough to overcome the dilutive impact of such capital raises and keep investor confidence high.

Look for Earnings Growth Above 20%
It should also go without saying that EPS (earnings per share) growth is necessary. Attractive early-stage growth stocks don’t need to be profitable. But they do need to be trending in the right direction, even if there is the occasional quarter or year where EPS ticks down due to investments, acquisitions or other short-term reasons. Earnings growth that’s faster than revenue growth is a plus as it shows the business has leverage to increase profitability as it gets bigger.

A Strong Chart
This seems like an obvious statement, but I still get tons of emails from subscribers wondering if an ailing stock is a “deal.” No! Sure, there are always examples of a beaten-down stock that pops on an earnings report or takeover. But what are the chances you can identify these opportunities with any regularity? Life doesn’t need to be that difficult. Buying on a pullback or a dip when the longer-term trendlines are still up is fine. But don’t try to be a hero.

Invest in Companies with Good Business Models
Big Trends and Big Ideas are great. But a company is only going to start gushing cash if management has developed and implemented a rational business model to seize the opportunity. The hard part for investors is that understanding a company’s business model takes time, and not all are willing to roll up their sleeves and get a little dirty.

Look for Repeatable Positive Events and Catalysts
Pick any stock and you can figure out at least one potential reason for it to go up. But management teams running early-stage growth stocks that deliver over the long haul need to do this repeatedly. Examples include new products that resonate with the market and help drive deeper, more profitable relationships with customers; and acquisitions that make sense, are aligned with the business model, are integrated relatively smoothly and were a more efficient way to acquire technology and talent than building from within.

Try Not to Sell Too Early
It’s incredibly hard to hold on to stocks for a long term when short-term noise and volatility pop up. That’s especially true when talking about early-stage growth stocks because a lot of them go through meaningful corrections, then take off again. That’s why it’s so important to focus on everything I’ve just said, from big trends to business models, to durability and scarcity premium. No single thing defines a great early-stage growth stock; it’s the sum total of many smaller things that matters, and which will give you the confidence to stick with it.

Have Your Own Opinion AND Seek Help
Investors are responsible for their own actions. You can read research reports from the best numbers guy or strategic thinker out there. But it’s your cash and your future. Be a skeptic, understand that even the best companies in the world are less than perfect. Your opinion of the stock’s potential is what brings the entire stock selection process full circle.

At the same time, most of us need help identifying early-stage growth opportunities, vetting them, and following along as a company matures. For those who are able, paying a few bucks to work with somebody that has a stock selection process that resonates and kicks out intriguing opportunities can be well worth it.

What are your personal rules for identifying early-stage candidates?