Published on April 13, 2017

While everyone would like to own the next Amazon or Netflix, the challenge is identifying likely winners and buying them at the right price. So how can investors tell the difference between shooting stars that have staying power and ones that don’t?

In a slow growth economy, it is challenging for large, established companies to drive meaningful growth. Those that are able to do so can draw the lion’s share of attention from investors and the general public. Aiming to invest in market-disrupting companies can be quite risky though; for every Amazon or Netflix there are dozens of also-rans that couldn’t sustain impressive revenue growth or translate that growth into consistent profitability.

Investing in such companies is a test of faith. It requires identifying a fundamental reason to own a stock over the long term and the discipline to tolerate price volatility. As we saw in the tech bubble of the late 1990s, many market darlings can quickly become market has-beens.

One key element for success is focusing on businesses that marry impressive revenue growth with demonstrable profit potential; those that can grow annual sales 20% or better and show rising margins over the next several years.

Evaluating that potential can be tricky. Management teams will set “stretch” goals to illustrate their vision. Be wary of any goals that aren’t attainable within 3 to 5 years or that require financial firepower beyond the company’s own resources. Plans needing future infusions of capital put management on a hamster wheel of fundraising to maintain a growth trajectory, a likely distraction from improving profitability.

There are multiple sectors where new companies are working to upend traditional business models. Consider the financial industry, where the well-covered rise of “fintech” has blurred the lines between interesting ideas and compelling long-term businesses.

Q2 Holdings, based in Austin, Texas, provides cloud-based digital services to regional and community banks. While consumers and businesses have grown comfortable banking online, not every financial institution has the resources to develop their own technology. Q2 fills that gap for smaller banks with customers who increasingly expect on-demand, go-anywhere service at their fingertips.

In 2016 Q2’s annual revenue grew 38%, and the percentage of revenue spent on sales and marketing continues to decline as growth investments bear fruit, making a strong case for future margin expansion and profitability as the company matures.

The term “disruptor” is often overused, but measuring such opportunities with a critical eye can surface intriguing investment possibilities.

James L. Callinan

Vice President & Portfolio Manager

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Opinions expressed are those of the author, are subject to change at any time, are not guaranteed and should not be considered investment advice.

Holdings and sector allocations are not recommendations to buy or sell any security.

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