One of the most enduring investment strategies is to invest in companies that are growing earnings per share rapidly and have a reasonable ratio of the stock's price to its expected earnings for the upcoming twelve months. For US companies, a desirable growth rate would be at least 15 percent year over year, and a reasonable price-to-earnings ratio (P/E) would typically be less than 25 to 30 times projected earnings.

To maximize returns while reducing risk, it is wise to concentrate on companies that have transcended the small, embryonic start-up stage but have not yet prospered and grown into huge, over-researched behemoths that have greater difficulty achieving a dynamic growth rate. Companies earning at least $3 million in after-tax income with at least three years of profitability create a reasonable "first look" threshold.

Most of America's largest 200 companies are either too large to sustain a 15 percent growth rate or too popularised to provide much opportunity for price-to-earnings ratio expansion. That doesn't mean good investments cannot be found among them, but it is less likely. Imagine the size and impact of a product required to grow a $10 billion company by 15 percent! It's better to isolate companies moving from #7 to #3 in their industries rather than high-profile market leaders that are in the precarious position of having to justify their high P/E ratios.

Severe bear markets, like the ones in 1974, 1987, 1990, 1994 and most recently in 2001-2002, are a not-so-subtle reminder that investors need a strategy "to invest under fire" when the bad markets come, as they inevitably will.

To this end, you must examine several conventional approaches this firm does not embrace and question some of these long-held axioms on Wall Street.

Questionable Axiom #1: It's Essential to Be Diversified

Thirty years ago being diversified meant owning the best steel company, the best oil company, the best bank, as well as the best chemical, paper, airline, and insurance companies. Such diversification offers the investor equal opportunity to participate in all the sick or tired areas of the economy.

A new definition of diversification arose with the advent of "asset classes" based largely on the market capitalization of companies -- midcap growth, small-cap value, large-cap core, and so on. Diversification among these "asset classes" failed to recognize that when Intel and Texas Instruments encountered headwinds, so did their midcap and small-cap counterparts in the semiconductor industry. For the most part, the semiconductor industry experienced declines across the board, regardless of market capitalization. In other words, earnings trends and stock-price movements correlate more closely to industry groups than to "style boxes."

This definition of diversification kept investors stuck in "large-cap growth" stocks at a time when our approach condemned them to the "outrageous" price-to-earnings category. Why own companies selling at 70, 80, or even 100 times projected earnings, even though their fundamental outlooks are positive, just because they have achieved a certain market-cap size?

It is more effective to redefine diversification in the context of societal changes, spreading one's risks among the hundreds of companies participating in these changes if they meet growth and P/E criteria and possess clean accounting and solid balance sheets. All investors have the ability to ask themselves, "How is society changing, and which companies are not only benefiting from that change but even orchestrating it?" If that means you don't own any steel, paper, or aluminum companies, that's OK.

What are some of these societal changes? Here are a few examples:

• Major technology companies are selling their manufacturing facilities to contract manufacturers.
• Hobby and craft companies are flourishing as people stay closer to home.
• Financial companies are refinancing home mortgages as interest rates fall.
• Rising unemployment has forced workers to seek retraining in new fields. (Corinthian Colleges, which educates healthcare workers, trains chefs, and qualifies others for new jobs, is prospering from this trend.)
• Advances in medical technology, such as intensity modulated radiation therapy (IMRT), have spawned hospital equipment purchases.
• Congestion in major airports has encouraged new business models in the airline industry. (Southwest Airlines and Jet Blue are thriving in smaller markets.)
• Especially in an environment where broad economic growth has slowed or even retraced, it is important to uncover these trends and societal shifts in order to isolate the companies that have the best prospects for future growth.

Questionable axiom #2: Active Management Won't Succeed -- So, Index

Indexing was partly responsible for the stock market bubble. Investors poured money into companies simply because they were a component of an index created by a committee at Standard & Poor's or Frank Russell. Companies were selected on the basis of their past track records. Indexing affords investors the opportunity to invest in sick and over-priced companies. The lethargy with which a company is removed from an index suggests little attention is paid to the day-to-day developments that can cause prospects to deteriorate.

To steer clear of this pitfall, be sure never to invest in the "stock market", invest in individual companies. Harness your own research techniques or those of your investment manager or advisor to isolate individual companies that fit your investment criteria, regardless into which index category others may assign it.

Questionable axiom #3: Buy Good Managements; Stick with Good People

The management factor alone won't guarantee success. We know a myriad of companies that lost their lustre through no fault of the competent people running them. It is important to have a business that is so well positioned that it doesn't take a genius to run it. As an investor in such businesses, it is crucial to have a mechanism to continually monitor the changing conditions that businesses encounter.

The more than thirty "detectives" of our research team conduct over 1,000 interviews a week not only with company managements, but also, more important, with their competitors, suppliers, and customers. Even so, it is easy to fail to give adequate weight to what might seem to be a trivial departure from the company's success trail. This is not an easy endeavor.

Questionable axiom #4: Stick to the Strategy You Have Selected

Religiously adhering to a strategy isn't sound unless the strategy itself is sound. Instead, our strategy of investing and closely monitoring proven companies that are growing rapidly, selling at reasonable price-to-earnings ratios, and have honest management and clean accounting is a sound strategy. Nevertheless, there will be times when other approaches are going to outperform. Investors must be patient and savvy enough to accept these periods and stay put to weather the "storms".

Often a fund can best be evaluated as a superior investment vehicle during years of underperformance rather than during years when it outperforms certain benchmarks. For example, Mutual Funds magazine's January 2000 issue, when highlighting Brandywine Fund as one of America's "best Funds of the Decade" said: "Any team can win the World Series or the Super Bowl in any given year, but bringing home the trophy year after year requires something special." What is "special" is not only the sound strategy, but also more important, the people who implement it.

In 1998, for example, instead of sticking to the owning companies with solid earnings growth and reasonable multiples, investors preferred to own the Wall Street darlings like Cisco, Dell, and Microsoft. Commitment to this approach caused several quarters of underperformance by Brandywine funds as the high multiple stocks began their ascent. This signalled investors' shift toward the "new paradigm" in which earnings no longer mattered, only revenue growth. But Brandywine funds' short term underperformance paved the way for superior performance during the subsequent bear market.

Questionable axiom #5: Buy Rapidly Growing Revenues; Think about Earnings Later

Focusing on revenue growth rather than on earnings growth we've come to call the I Love Lucy method of investing. In one episode, Desi and Fred confronted Lucy and Ethel with the fact that they were losing ten cents on each jar from their kitchen-based jam-mak­ing venture. "We'll make it up in volume," Lucy retorted. The crite­ria of three years of earnings history and $3 million of after-tax income before a company crosses the Friess radar screen shielded Friess Associates clients from the bursting of the dot-com bubble. Three things determine a stock's future value: (1) earnings, (2) earn­ings, (3) earnings.

Bottom Line

You would do well to ignore many of the established Wall Street axioms and instead target companies that are growing nicely (at least 15 percent year over year) and are selling at reasonable P/Es (under 30 times forward earnings). Then put them under your microscope to make sure the accounting is clean and earnings are real. Although subscribers to this strategy will underperform at times, don't fear, at this strategy will most likely stand the test of time through good and bad markets.

Excerpted from Investing Under Fire edited by Alan R Ackerman. Price Rs 395. This chapter is written by Foster S Friess, founder and chairman of Friess Associates, which manages approximately $5 billion in assets for its clients.

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