Growth Stocks August 09, 2026
The Idea
August is often a useful month for portfolio housekeeping. Earnings season has delivered fresh data, liquidity can thin out, and investors start looking ahead to year-end positioning. One of the cleanest screens for durable growth businesses is the Rule of 40: a company’s revenue growth rate plus profit margin should equal or exceed 40%.
The appeal is simple. High-growth companies can look exciting but burn too much cash. Highly profitable companies can look safe but lack reinvestment opportunities. Rule of 40 firms sit in the middle of that tension. They are growing fast enough to expand their opportunity set while showing enough operating discipline to avoid relying entirely on capital markets.
For long-term investors, that combination matters. Charlie Munger often emphasized the power of great businesses that can reinvest capital at attractive rates. The Rule of 40 is not a magic formula, but it is a practical way to identify companies where growth and financial quality are working together rather than fighting each other.
How It Works
The Rule of 40 is most commonly used for software, internet, payments, data, and other asset-light businesses. The basic calculation is straightforward:
- Revenue growth rate plus profit margin equals the Rule of 40 score.
- If revenue is growing 25% and operating margin is 18%, the score is 43%.
- If revenue is growing 45% but margins are negative 20%, the score is 25%.
- If revenue is growing 8% and margins are 35%, the score is 43%.
Investors can use different margin definitions, but consistency matters. Free cash flow margin is often preferable because it captures real cash generation. Operating margin can also work, especially when comparing companies within the same industry. The key is not to mix aggressive adjusted metrics with conservative accounting for peers.
The logic behind the rule is that growth has a cost. A company spending heavily on sales, marketing, product development, and infrastructure may deserve lower current margins if those investments produce durable revenue expansion. Conversely, slower-growing companies must prove they can return cash to shareholders or maintain high margins to justify premium valuations.
The best Rule of 40 businesses typically share several traits: recurring revenue, high gross margins, low customer churn, pricing power, strong balance sheets, and management teams that know when to accelerate and when to harvest profits. These are the companies that can shift between growth and profitability without breaking the model.
Why This Has Worked Historically
The Rule of 40 became popular in private equity and venture software investing, but its roots are consistent with older investing principles. Warren Buffett has long favored businesses with durable competitive advantages and high returns on capital. Peter Lynch looked for companies that could grow earnings for many years without depending on heroic assumptions. Howard Marks reminds investors that quality and price both matter, especially when market psychology swings from greed to fear.
A concrete example is Microsoft after its business model began shifting more aggressively toward cloud and subscription revenue in the 2010s. The company combined healthy revenue growth with rising margins, massive free cash flow, and a strengthening competitive position. Investors were not rewarded merely because Microsoft was “tech.” They were rewarded because the business showed durable growth, operating leverage, and disciplined capital allocation over many years.
Another lesson came from the 2021-2022 growth-stock reset. Many fast-growing companies had impressive revenue expansion but weak margins, heavy stock-based compensation, and limited evidence of future cash generation. When interest rates rose and investors became less willing to fund distant profits, those businesses were repriced sharply. In contrast, companies with real earnings power and strong free cash flow generally held up better and recovered more credibly.
That episode reinforced a point Aswath Damodaran has made repeatedly: valuation is ultimately tied to cash flows, growth, risk, and time. Growth is valuable only when it can eventually translate into cash returned to owners. The Rule of 40 helps investors separate productive growth from growth purchased at any price.
How to Apply It Today
Investors do not need to build a complicated model to use the Rule of 40 effectively. A disciplined checklist can improve portfolio quality, especially during August review season when recent earnings reports provide updated evidence.
- Start with revenue durability. Look for multi-year growth, not just one strong quarter. Recurring revenue, repeat purchases, usage-based expansion, or mission-critical products are positive signs.
- Use free cash flow margin when possible. A business that converts revenue into cash has more flexibility to invest, repurchase shares, reduce debt, or withstand downturns.
- Compare companies within the same industry. A 40% score means different things in software, industrial technology, healthcare services, or digital advertising.
- Watch the trend. A company moving from 32% to 38% may be improving faster than one slipping from 55% to 42%.
- Check balance sheet strength. Durable growth is more valuable when it is not dependent on refinancing, dilution, or favorable credit markets.
- Demand valuation discipline. Even excellent businesses can disappoint if purchased at prices that assume perfection.
A practical August portfolio exercise is to rank holdings by Rule of 40 score, then compare that ranking with position size. If a large position has slowing growth, deteriorating margins, and a stretched valuation, it deserves scrutiny. If a smaller holding consistently clears the hurdle, expands margins, and retains a long runway, it may merit deeper research.
This is not about chasing the highest-growth name on a screen. It is about finding businesses where growth, profitability, and balance sheet strength reinforce one another. That is the kind of compounding profile that can survive changing market narratives.
Risks to Keep in Mind
The Rule of 40 is useful, but it can be misapplied. First, it is not universal. Banks, insurers, commodity producers, utilities, and early-stage biotech companies often require different analytical frameworks. For these businesses, capital ratios, reserves, commodity cycles, or clinical milestones may matter more than revenue growth plus margins.
Second, accounting quality matters. Adjusted margins can exclude real costs, especially stock-based compensation. A company may appear to clear the Rule of 40 while diluting shareholders heavily. Seth Klarman’s margin-of-safety mindset is helpful here: do not accept management’s preferred numbers without understanding what they leave out.
Third, competition can erode today’s score. High margins attract rivals, and fast growth can slow as markets mature. Investors should look for evidence of moats: switching costs, network effects, brand strength, scale advantages, proprietary data, or regulatory barriers.
Finally, valuation can overwhelm business quality. Nassim Taleb’s work on fragility is a reminder that portfolios should be built to withstand surprises. A basket of durable Rule of 40 companies may be more resilient than speculative growth stocks, but it is not immune to multiple compression, recession risk, or execution mistakes.
The right approach is to treat the Rule of 40 as a starting point, not a final answer. Used alongside valuation, competitive analysis, and balance sheet review, it can help investors tilt August portfolios toward companies with the rare combination of growth that lasts and profitability that matters.
