How to Profit from Growth Stocks in a Volatile Market

Weve talked before about the re-emergence of volatility. The market calmed down in February, but dont let that fool you. As weve seen, March has already gotten off to a shaky start. Just look at todays action. It was a good news is bad news situation, as an unexpectedly strong jobs report gave rise to concerns that the Fed might now raise interest rates sooner than expected.

This action is telling me that we could be again entering a nervous trading environment, with a lot of backing and filling of stocks. Its possible the market will get choppier for a while, possibly even through April when well have a better read on first-quarter earnings.

Its important to understand that you can still be invested and make good money in a more volatile environment rather than head for the sidelines. Weve discussed a few of those ways, including value investing, which leads us to deeply discounted stocks, and using technical analysis to identify buy and sell prices in stocks ready to break out.

Today, I thought we would talk about growth investing in a more volatile environment. Some investors may feel they should stay away from growth stocks, which are generally higher risk but also frequently present more upside potential.

I think thats a mistake. You can invest in growth stocks even when things are choppy, but you do need to be a bit more careful. First and foremost, I recommend you pay closer attention to valuation. Investors are often willing to pay up for growth stocks precisely because of the growth, which they believe will make the company much more valuable in the future. And that is often the case. There are times and situations in which Im also willing to buy stocks that are richly valued.

Growth at Reasonable Prices

But in a volatile market, growth at a reasonable price often referred to by its acronym GARP can reduce your risk. Stocks selling at high price/earnings (P/E) ratios are often among the first and hardest hit by selling when investors get nervous.

So for starters, I would be leery of investing in some of these more richly valued stocks at a time when the market as a whole is starting to look rich at an implied multiple of 17.2X forward earnings, and analysts are now informally bearish on earnings growth over the next two quarters.

For example, Tesla (TSLA) is frequently a momentum darling on Wall Street, but the company has not produced enough profits to have a P/E ratio from the last 12 months and is now selling at more than 200X expectations for 2015 earnings. As much as I respect founder Elon Musk, thats too rich for me. There could be very short-term trade opportunities in TSLA, and weve done that using options in High Octane Trader. but I wouldnt recommending buying here for a longer-term holding.

Focusing on Growth Companies

The good news is that you can find companies that are showing consistent earnings growth above broad market levels but still do not sport excessively high valuations.

This is a strategy Ive used over and over again in my GameChangers service. We focus on growth companies, and in the current environment, were especially focused on companies with solid fundamentals, specific catalysts to drive the stock price and reasonable valuations. Because of this, weve been able to lock in nice profits in stocks even on market down days.

For example, I recently recommended a cloud computing company whose software solutions help to streamline business operations, connect enterprises to their clients in real-time, as well as adapt to meet rapidly changing requirements. Its products are used by some of the biggest names in business, including Fortune 500 companies like Cisco Systems (CSCO), Bank of America (BAC) and PayPal just to name a few.

To me, this is a stock worth owning in a market that could be slowing down. It sells for 25X expected 2015 earnings, and in a market where many names are extended, this stock stood out as a good buying opportunity. I continue to like the companys growth prospects and feel that downside risk is limited.

Knowing When to Sell

Equally important is knowing when to sell a stock that becomes fully valued and therefore more vulnerable to a pullback. We just did this with DigitalGlobe (DGI), which had soared nearly 17% after reporting better-than-expected fourth-quarter earnings. I was very pleased with the results, but after taking into consideration managements goal to eventually achieve $1 billion in annual revenue, some further margin expansion and expected reduction in capital spending as DGI completes the building of its constellation system, I felt that the stock was pretty fully valued at current prices around $35.

Digging deeper into the valuation analysis, if you discount DigitalGlobes free cash flow potential of $270 million annually and discount this number back by 8.5% (derived by applying a 3% premium to the 5.5% yield on DGI bonds), a target of $35 is a full price. Plus, DGI stock is trading around 10 times projected 2015 EV/EBITDA (enterprise value/earnings before interest, taxes, depreciation and amortization), which is another indication of full value.

And given the companys history of inconsistent earnings and tendency to selloff sharply whenever investors grow uneasy, I felt that further upside would be a lot harder to come by. With the risks now outweighing the reward, it was time to lock in our double-digit gains and move on to other opportunities with more upside potential.

So growth stocks can still make you good money in a more volatile market, but I do think its smart to avoid the richly valued high fliers that are more vulnerable when investors get nervous and focus on companies with strong fundamentals and a reasonable valuation. They really are out there if you look hard enough. Thats one of the things I do for my GameChangers subscribers. We take advantage of a new opportunity pretty much every week, and if youre interested in getting on board for the next one that Im working on now, you can click here for more information .

Posted by Hilary Kramer on March 6, 2015 4:28 PM | Permalink