Investing in growth stocks can be a very lucrative experience. I’ll go ahead and tell you, right off the bat, that I am no expert on growth stocks. While I have read extensively on the subject I prefer to stick to value stocks, as I see investing as a long-term game and perhaps because I don’t have as much appetite for risk as others.
And that’s the thing, no risk, no rewards, and that is what you will find in the world of growth investing.
What is a “Growth Stock” ?
A growth stock is a share in a company that is anticipated to grow at a rate significantly above the average for the market.
Normally, these stocks don’t pay dividends, mostly because of what I explained in my dividend stock article. These companies, since they are expected to grow a lot, would rather reinvest their earnings to accelerate this growth. Investors then earn money through capital gains when they eventually sell their shares.
Capital gains, simply mean that the asset in question increases in value, in this case, the company. To realize a capital gain the asset has to be sold. Of course, the counterpart of a capital gain is a capital loss.
Most growth stocks today can be found in sectors such as technology, biotech, and some consumer discretionary samples
Characteristics of a growth stock
When it comes to growth stocks, there are a few traits which we can identify to distinguish them from other stocks.
A lot of growth companies, hold a privileged position in the market, this is how they can achieve higher than normal growth rates. They may hold patents or have access to technologies that competitors don’t.
For this precise reason, these companies may also have a very loyal customer base, and could also have a large portion of the market they are in.
A company that has a completely innovative idea, will, by default have a very large market share, if not all. Think of companies like Uber.
Although there are alternatives now when Uber began it was the only ride-sharing app available on the market. Once the idea took off, it was easy for Uber to expand at an accelerated rate.
The same would apply to, say, a pharmaceutical company that holds the patent for a new drug. They would automatically take the whole market share.
It’s important t understand though, that growth is not forever, or at least the accelerated type of growth we expect from these types of company.
Even innovative companies can be displaced. They may have the advantage of being the first to offer a service, but that doesn’t guarantee that they will be the best at it in the future, and copying an idea like Uber, is actually rather easy.
Growth Stocks vs. Value Stocks
You may be wondering: What’s better, value or growth stocks? What’s the best choice for me?
Growth stocks are different from value stocks. Investors expect growth stocks to earn substantial capital gains. This expectation can result in these stocks being overvalued. Value stocks on the other hand, often are underrated or ignored by the market. They may eventually gain value, but investors also attempt to profit from the dividends they typically pay.
It’s important to try to include both growth and value stocks in their for diversification.
Some value stocks are underpriced due to poor earnings reports or negative media attention. However, they often still have strong dividend payout histories. A value stock with a strong dividend track record can provide reliable income to an investor. Many value stocks are older companies that can be counted on to stay in business, even if they aren’t particularly innovative or poised to grow.
What makes a good growth stock
Now that we know what growth stocks are, we can learn to separate the good ones from the bad ones.
Here are some of the attributes which you’ll find in good growth stocks.
Large target market
The bigger the pool of potential customers, the more likely a company will grow quickly. A company can’t become huge by serving a small niche market. It needs to appeal to a broad audience, potentially, everyone in the world.
Strong sales growth
I think it comes without saying, that a large target market is only useful if this materializes into sales.
One of the best indicators of a company’s potential is its sales growth.
What we want to see, optimally, is a steady and regular growth in earnings being driven by higher sales.When it comes to the growth rate of a winning stock, there isn’t any hard and fast rule but you do want to go with a company that has at least high double-digit growth. Many highflying growth stocks see triple digit growth rates in the beginning and a slower growth rate as the company and industry matures.
Valuation
Just because we are talking about growth stocks, doesn’t mean valuation isn’t important.
Growth stocks can be over or undervalued, just like any other stock, sometimes more. Because growth stocks trade on the expectation of high growth, it’s important not to get caught out in the trap of buying a company well above its actual current and even potential value.
How do we achieve this?
P/S and P/E can be two good ratios to take a quick look at when thinking about a growth stock. A reasonable P/S ratio with the expectation for high sales growth can be a good sign for the future stock price. A flat P/E to forward P/E or a forward P/E that is below the historical average can also mean the stock has a great deal more room to move higher.
A business in a fast-growing market
One of the most important factors determining any companies growth is the overall market growth. It’s common sense really, even the best run most efficient company if the industry it’s in is not growing and instead is becoming obsolete.
Put it this way, I don’t think any degree of wizardry could have saved blockbuster from going out of business.
Growth companies should be found in sectors that are booming. This is why at the beginning of the article we mentioned technology and biotech as some of the examples of industries to find good growth stocks.
As well as finding a growing market, it’s important to identify a business which can actually capitalize on this.
A lot of businesses come up with a great product, but then fail to keep up this level of innovation. If a company wants to grow at +10% every year it has to be able to stay ahead of the competition and constantly reinvent itself.
Find a company with excellent management
There’s been a lot of talk on this subject in recent years.
CEOs have become like rock stars in the last 20 years. They command a lot of respect and have incredibly high salaries, not unlike professional athletes and entertainers.
Is this level of pay justified?
It’s hard to say. I am of the opinion that some CEOs and managers are grossly overpaid. But the truth of the matter is, in most cases, the quality of management in a company will make a huge difference.
Think of people like Steve Jobs, Bill Gates or Mark Zuckerberg. Yes, they had a great product, but there are many computers out there other than Apple. There are alternatives to Facebook such as MySpace. But these individuals, with the help of those around them, managed to build multibillion-dollar industries.
It’s important to remember that, at the end of the day, a conpany is nothing more than a group of people putting some effort and resources together. So if you can, take a hard look at who are the people behind the companies you are looking to invest in.
Understanding the people running the company is the best way of understanding the company and where it’s going.
Conclusion
Growth companies thrive more in healthy and expanding economies. After all, growth is the product f increased demand and consumer spending.
Having said this, a downturn can also be an opportunity for a company to pull itself apart from the rest of the herd.
If you are interested in investing in growth stocks, I’d invite you to read more about it. There are great resources available online.
However, bear in mind what I said before, growth investment, in my opinion, is not for the amateur investor. It takes a great degree of skill to analyze growth stocks and constant and active upkeeping with the company and industry as a whole.
As always, I think that growth stocks can be a part of a diversified portfolio, but proceed with caution.
