The most difficult problem facing growth-oriented investors is: How can you be sure that today's growth stocks will not become tomorrow's flops? Past performance is no guarantee of future action. The market has too often based its valuations on the assumption that what has gone before will continue for an indefinite period, which is, of course, by no means true.

How, then, do you go about determining a company's future in terms of today's price? The key problems revolve around price and the prospects for sustained future growth.

A stock selling at 20 times earnings might be a better buy than a stock selling at 10 times earnings. Or, it might be overpriced in relation to future profit. Obviously, the conventional criteria cannot be applied to this group; most growth stocks always look high in relation to the market average.

Some investors have become so frustrated in a proper valuation of growth stocks as to believe that it's simply an impossible job. But it's not—if you know how.

A company's growth record and its realistic appraisal in terms of market value provide us with a solid base for valuation. That's only the beginning, however. Too many of what were top growth stocks have failed to maintain their growth pattern or slowed down to a degree quite incompatible with their high market valuations.

A sensible way is, of course, to constantly examine and reappraise a given situation through a close (preferably, on-the-spot) observation of the company and its managers and through a continuing study of its product sales potentials in order to be kept up-to-date.

A system of uncovering growth companies was initiated in September 1961 by Standard & Poor's Corporation, the nation's largest investment advisory service, when it unveiled its list of 200 "Rapid Growth Stocks" which were selected out of several thousand companies. The selection was made with the help of an electronic data processing technique which makes it possible to comb through a vastly larger universe of companies than could be processed by older methods.

The initial 200 "Rapid Growth Stocks" (which were increased to 300 stocks on October 23, 1961, with more additions to come) include 113 over-the-counter issues. There are 35 stocks trading on the American Stock Exchange and 52 listed on the Big Board.

Naturally, not all of the 200 or 300 stocks are in equally good buying ranges on a given day. The best-positioned of them are recommended in S. & P.'s weekly Outlook which has an eight-page supplement devoted to the 200 "Rapid Growth Stocks"—statistical material, charts, graphs and news about the companies.

In its first selection, S. & P. suggested the purchase of nine of these stocks—including seven from the Big Board. One off-board pick was Hamilton Management Corporation, which distributes and manages the $250 million Hamilton Fund, a mutual fund. The other selection was Swingline, Inc., leading maker of staples and staplers.

Its second selection of five stocks included one off-board stock (Merchants Fast Motor Lines), one from the Little Board (Colonial Corporation of America), and the rest from the Big Board— Crown Cork & Seal, Procter & Gamble, and Suburban Gas.

Here are key statistics from S. & P.'s tabulation of the five growth stocks:

Growth rates
                                               
                                                                        Current             Growth
                                                5-yr. Trend       yr. est.              premium
                                                %                     %                     %
Colonial Corp. of America        38.7                 61.3                 +12
Crown Cork & Seal                118.5                90.5                 — 8
Merchants Fast Motor Lines   18.8                   31.0                 —20
Procter & Gamble                    10.4                 8.1                   +82
Suburban Gas                           28.0                 20.0                 +36

This tabulation should serve as a "model" method for calculating earnings growth rate and growth premiums or discounts. While the average five-year growth rate reveals its general growth trend over an extended period of time, the current year's growth rate, together with estimated earnings, should serve as an immediate basis for market valuation.

On the other hand, growth premium or discount is a comparison of a given situation with the S. & P. 425 Industrials in terms of price-earnings ratios. As you can readily see from the tabulation, not all growth stocks sell high in relation to the rest of the market. As a matter of fact, two of them sold at a discount, with—8 per cent for Crown Cork & Seal, and—20 per cent for Merchants Fast Motor Lines.

Here are the key growth considerations taken into account by S. & P. analysts:

Colonial Corporation of America: Though operating in the unglamorous field of manufacturing and distributing low-priced shirts for men and boys and blouses for women, the company has little direct competition, being virtually alone in its price range. It has enjoyed a compound earnings growth of 38.7 per cent annually since 1955.

Crown Cork Sc Seal: Following a deficit of l4¢ a share in 1956, a new management group took over and as a result of extensive cost reduction programs and elimination of unprofitable product lines, earnings in 1960 rose to a new high of $3.15 per share, which should rise to the $6 level upon consummation of the proposed merger with the 51-per cent-owned Crown Cork International. The company expects to have an annual increment of $1 per share in earnings over the next few years.

Merchants Fast Motor Lines: Selling at 20 per cent discount relative to the S. & P. 425 Industrials, this unlisted stock appears to be an unrecognized value, especially because of the following statistics: Its operating ratio—77 per cent in 1960—is the best among publicly owned truckers, and its return on net worth— 22 per cent in 1960—is about double the industry norm.

Procter & Gamble: The company has a solid past and is expected to continue its strong growth trend because of its anticipated continuing success in new product development and marketing despite intense competition in the fields of soaps and toiletries. Its growth potential should be also helped by its expanding foreign operations.

Suburban Gas: One of the West Coast's two largest distributors of LP Gas, principally propane and butane, the company has an outstanding record of earnings growth and consistent dividend increases. Its business is characterized by the following growth factors: (1) population shift to the suburbs, (2) rise in vacation and other casual activities involving country residences and resorts.

Another system for uncovering growth stocks is devised by John S. Herold, Inc.'s America's Fastest Growing Companies, a monthly publication which concentrates on companies which are compounding their earning power and value at the highest rates. It is a good place to seek young but solid companies with excellent growth potential.

The publication's selection of companies is based on growth in net income per common share, which is undoubtedly the most reliable yardstick of measuring a company's real growth. Of 5,000 companies screened, only those companies recording the largest and most consistent year-to-year gains in earnings have been selected. An additional requirement is that every company, when first listed, show an uninterrupted gain in annual profits for three years immediately preceding.

Why a minimum of three years? Because any lesser period would be far too short to be indicative of any reliable growth trend. Stock buyers might be deceived by the temporary prosperity of a youthful growth company.

Every issue of America's Fastest Growing Companies gives comparative tables, charts and statistics on the 140-150 companies in the United States which are compounding their earnings to the highest degree, and this should bring into proper focus the relative attraction of every stock, based on its growing power and growth rate.

Other things being equal, professional analysts prefer stocks with a small capitalization (a small number of shares outstanding). Why small capitalization? Because maximum effectiveness in per-share earnings is more likely to be achieved in situations where there are not too many shares outstanding. If a company has millions of shares outstanding, even substantial earnings gains would not have too much effect on per-share results.

The emphasis laid by America's Fastest Growing Companies on growth in net income per common share seems to be an indirect way of taking the size of capitalization into consideration.

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