The Motley Fool

Two More Strategies For Beating The Market

Two months ago I laid out two of my favourite strategies for beating the market – scooping up i) industry leaders during a panic, and ii) companies going through substantial transitions.

Now I’m back with two other favourite investment approaches and these two are as old as the market itself – growth and income.

5G is here – and shares of this ‘sleeping giant’ could be a great way for you to potentially profit!

According to one leading industry firm, the 5G boom could create a global industry worth US$12.3 TRILLION out of thin air…

And if you click here we’ll show you something that could be key to unlocking 5G’s full potential...

Sure, both are traditional and easy to understand, but there’s more to each strategy than buying a company with rapidly rising sales or with a yield above a certain level. I see them first and foremost as starting points. Other important qualities need to be present, too.

You need to have a different opinion

It sounds crazy, but the market sometimes underestimates the growth potential of fast-growing companies – even ones that look expensive at first glance with P/E ratios of 25 or more.

Usually, this phenomenon occurs because the market can’t grasp how rapidly a company could grow in the long term or how long it can maintain an above-average growth rate.

The first situation is usually a bit easier to judge.

For example, if we assume a company has a P/E ratio of 25 and it looks likely to grow its earnings by 30% or more in the next year, it could still be deemed attractively priced. The same may be true if the company can grow its earnings by 20% a year for two years or more.

For me, a high-quality business that can offer either of these growth projections is definitely worth a second look.

Let’s again say a company has a P/E ratio of 25, but in this case it’s clear it won’t grow earnings by 20% or 30% a year in the near future.

But there still might be an opportunity, because in my experience the market often doesn’t look more than a year or two into the future. So, the shares could still be attractive if you believe the company can grow earnings at 10% to 15% a year for five years or more.

Investments such as these can deliver substantial returns, because of the power of compound growth.

And sometimes a share will have the potential to succeed on both criteria…

The combination of events has led to the share price rising nicely

This was my assessment last March with healthcare specialist BTG (LSE: BTG), when the shares had a P/E ratio of 30 .

My research led me to believe a new royalty stream alongside sales growth from existing products would allow the company to grow near-term earnings by 25% or more. In future years, I saw the opportunity for new product launches to generate sustainable growth of 10% or more for five years.

It helped BTG’s executives boasted a track record of meeting their own plans and expectations. Fortunately, they did so again as earnings in 2013 increased by 28% and BTG received regulatory approval for a new product in December. That product should sustain the company’s double-digit growth for the next few years and the combination of events has led to the share price rising nicely.

It’s also been a great way to beat the market

Filling out a portfolio of companies with above-average yields used to be one of the easier strategies to implement. Traditionally, it’s also been a great way to beat the market as various studies have shown.

But with rates on 10-year gilts below 3%, bond investors have increasingly turned to shares to satiate their appetite for income.

Unfortunately, they’ve also reduced the number of attractive shares available with yields of 4% or more. Such yields are still out there, of course, but from a standing start it’s now more difficult to build a portfolio of high-quality companies with large dividend yields.

Look for a slightly lower yield and high dividend growth potential…

In the current environment, I think a dividend-focused portfolio should start with the high-quality companies with yields near (or even above) 4%. But if few are available, I’d move to a focus on dividend growth.

For example, Unilever and its 3.7% yield fits the high-quality and high-yield criteria perfectly and if you can find others, that’s great. But if you can’t find suitable candidates, I’d favour a yield closer to 3% with strong dividend growth potential, rather than a 4% yield of questionable quality or limited growth potential.

The dividend was increased by 13% and the shares haven’t looked back

I like to think about it like this. If you buy a share for 500p with a 14p dividend you’re getting a 2.8% yield today. If the company can grow that dividend by 10% a year for three years, the dividend will grow to more than 18p and if you hold onto the shares you’ll receive a 3.7% yield on your purchase price.

Companies that can deliver this type of growth generally pay out a relatively small proportion of their free cash flow as dividends. I like to see the dividend below 35% of free cash flow, and the ability to grow cash flow – or earnings – by 5% – 10% a year for three to five years.

This is the situation I saw last May with sandwich specialist Greencore (LSE: GNC), because of its above-average growth potential in the US. At the time, its shares yielded 3.4% and I believed cash flow could grow by at least 10% a year. In fact, the full-year results showed growth a bit better than I had expected as the dividend was increased by 13%. The shares haven’t looked back.

What they all have in common

I like both of these methods for trying to beat the market and believe they work well as long as certain other basic traits are in place. These traits include capable and trustworthy management, an easy to manage level of debt, and high-quality earnings.

With those qualities in place it’s relatively easy to start looking for the companies that fit one of these market-beating strategies.

“This Stock Could Be Like Buying Amazon in 1997”

I'm sure you'll agree that's quite the statement from Motley Fool Co-Founder Tom Gardner.

But since our US analyst team first recommended shares in this unique tech stock back in 2016, the value has soared.

What's more, we firmly believe there's still plenty of upside in its future. In fact, even throughout the current coronavirus crisis, its performance has been beating Wall St expectations.

And right now, we're giving you a chance to discover exactly what has got our analysts all fired up about this niche industry phenomenon, in our FREE special report, A Top US Share From The Motley Fool.

Click here to claim your copy now — and we’ll tell you the name of this Top US Share… free of charge!

> Nathan owns shares in Unilever. The Motley Fool has recommended shares in BTG and Greencore. The Motley Fool owns shares of Unilever.

Our 6 'Best Buys Now' Shares

The renowned analyst team at The Motley Fool UK have named 6 shares that they believe UK investors should consider buying NOW.

So if you’re looking for more stock ideas to try and best position your portfolio today, then it might be a good day for you. Because we're offering a full 33% off your first year of membership to our flagship share-tipping service, backed by our 'no quibbles' 30-day subscription fee refund guarantee.

Simply enter your email address below to discover how you can take advantage of this.

I would like to receive emails from you about product information and offers from The Fool and its business partners. Each of these emails will provide a link to unsubscribe from future emails. More information about how The Fool collects, stores, and handles personal data is available in its Privacy Statement.