The goal of any investment strategy is simple – maximize returns. So what makes growth investing different? Well, with growth investing you’re buying stocks that can produce a significantly higher average rate of return than the overall market.
Let’s look at how it is done.
What is growth investing?
Growth investing is an investment strategy that focuses on increasing your invested money. Even though that is the objective of all investing strategies, a growth investing strategy focuses on growing your capital faster than the overall market. This strategy advocates investing in stocks that are poised to grow significantly, or have room for aggressive expansion. Generally, these are smaller companies. It would also mean investing in companies, industries, or sectors that are currently growing or expected to grow continuously over a long period of time.
A growth investing strategy is more of an ‘offensive’ investment where the objective is to generate greater returns on your investment. Whereas in a defensive strategy, you invest in dividend stocks or blue-chip stocks where the objective is to generate a passive income from your investments while protecting it from downturns.
A long time horizon is a great advantage for investors. This is especially true for growth investing. As companies tend to be smaller, they might take more time to grow and generate returns for their investors. As with any investment, the more time you stay invested, the more valuable the investment will be. And that coupled with the higher growth rate of these stocks will give you superior returns.
With growth investing, the focus is on capital appreciation. Even though that is the focus on most investments, with growth stocks that’s the only way you’ll make money, as it’s unlikely that you’ll receive dividends. This is because growth stocks are generally newer or smaller, growing companies and they might use the cash to improve their products, expand their services, or invest in R&D. This is important because many investors use the cash from dividend payouts as a passive income from their investments. With growth investing, that might not be possible.
Types of growth investments
A growth stock can be from any industry, sector, or geography. However, these are some of the most popular types of growth stocks.
Even though the term ‘small-cap’ is loosely defined, companies with a market cap between $300 million to $2 billion are generally considered small-cap stocks. They are relatively new companies and have a lot of room for growth. With a lot of room for growth comes room for substantial earnings growth. Whereas large-cap stocks tend to have an annual growth rate of 4 – 7%, a good small-cap stock can have an annual growth rate between 15 – 20%. Bear in mind that this can be as much as 100%, or more, depending on the company and the overall industry.
Note that most of these companies might be really small and they might not even be profitable. That makes the stocks highly volatile, and stock prices might fluctuate more frequently. It is up to each investor to decide whether or not to go with growth stocks, as the risk tolerance varies from investor to investor. But if you do proper homework, small-cap stocks can be greatly rewarding.
High growth industry stocks
Like I said, even though a growth stock can come out of any sector, these are sectors that have consistently produced growth stocks.
Companies that deal with technology tend to be potential growth stocks. As the world is driven by new advancements in technology, smaller companies that come up with innovations in software, hardware, or devices could very well increase their revenue and earnings substantially, which in turn will be reflected in the stock price.
However, keep in mind that not every technology company is going to the next Google or Facebook, just like not every electric vehicle manufacturer is Tesla. Blindly going behind a company just because it has something to do with technology, is the same as you betting your money on the roll of a dice.
Healthcare is another sector that usually has plenty of growth potential. As everyone needs to visit a hospital or get treatment at some point in their life, healthcare companies are constantly trying to come up with new medicines, medical devices, treatments that will help people take care of their health. Innovative and revolutionary drugs can change the future of these companies.
Intellectual property is one of their major assets. That includes patents, licenses, approvals, etc. It gives them a key competitive advantage over their competitors (referred to as moat) and significantly increases their earning potential. As the IP is an intangible asset, it cannot be measured in a balance sheet. So, healthcare companies usually have a higher Price-to-earnings ratio (P/E) compared to other industries.
Growth investors can also choose exchange-traded funds (ETFs) that are focused on healthcare and technology stocks. These ETFs will simplify diversification and research for growth investors.
Researching growth stocks
To start, you should know that there is no universally accepted format for the valuation of growth stocks. However, as growth is the priority here, these are some of the metrics a growth investor looks at;
While investing in established companies, it’s easy to look at past performance and speculate the future performance of the company. But with growth stocks, most might not have historical earnings, as they are generally newer companies. While this might seem like a disadvantage, this presents an opportunity. Look for the company’s projected earnings growth – you can either look at analysts’ forecasts (given that analysts are covering these stocks), or you can do it yourself.
Firstly, understand the business model and its power to generate profits over the long term. Look for any key competitive advantages that set the company apart from its competitors. Make sure you see a path to profitability for the company. Once you understand its earning potential, make sure to check back on their earnings reports released quarterly.
Profit margin is calculated by deducting expenses from revenue (sales) and dividing by revenue. Pay attention to profit margin, because that’s an indicator of how good the management of the company is. Generally, if the company’s revenue is rising, but profit margin stays low, it is an indication that management is not doing a decent job in cutting costs and expenses.
However, with growing companies, they might need to spend a lot of money on advertising, marketing, and expanding their operations. This might have a negative impact on the earnings. Keep in mind that this effect is short-term. Once the company establishes itself in the industry, the expenses will decrease, generating greater earnings and returns for the shareholders. In such cases, it’s better to study the company’s management, their experience, and track record, as they will be key in the future of the company.
Return on Equity (ROE)
Return on equity is a measure of the profitability of a company. It is obtained by dividing net income by shareholder equity (money from investors) and expressed in percentage. It is a measure of how much profit the company generates using the money invested by shareholders.
For example, if one company has shareholder equity of $100 million while another has $400 million and both have managed to generate a net income of $50 million, then the first company has a greater return on equity, as it is generating the same net income with lesser equity.
Generally, a stable or increasing ROE tells you that the company is putting your money to good use. When using stock screeners, you should ideally look for companies with an RoE of more than 15%.
Growth and value stocks
Growth investing and value investing are generally portrayed as diametrically opposed approaches. This is misleading. Both growth and value investing aim to bring value to investors. While value investing is defined as buying stocks that are undervalued i.e trading under their intrinsic value, most of the time growth stocks are undervalued. The reason is, growth stocks tend to be smaller companies and the media and analysts tend to overlook these stocks, which results in the stocks being undervalued. So the value investing principle of buying undervalued stocks is followed in growth investing.
Similarly, it is important to keep value principles while investing in growth companies. Because both investing strategies aim to do one thing and one thing only – maximize value for investors. So growth investors should try to buy stocks at a lower price to enjoy the maximum return. This investment strategy that aims to buy growth companies using traditional value investing indicators is known as Growth at a reasonable price (GARP).
Incorporating growth investing into your investment strategies can be extremely rewarding. Make sure that the different aspects of growth investing including high volatility aligns with your investment goals. With any investment make sure that you do your due diligence before you invest. Study the company and the industry, look for competitive advantages that set the company apart from its competitors, and always look at the long term. Remember, with growth companies, we buy stocks we are content holding for at least the next 5 years.
When done right, growth investing can give superior returns over the broader market.
Wondering where to start? Check out our top 3 growth stocks for 2021.