Growth stocks are typically rapidly expanding younger companies with above-average growth rates. While growth investing can be a hugely rewarding strategy, it also comes with high risks and certainly isn’t for everyone.
This guide will help you decide if it is for you and get you started – we’ll explain what growth investing is, key metrics to identify them, the main risks involved, how to strategically manage these risks, and bring some examples of growth investing strategies.
What are growth stocks?
Growth stocks are companies experiencing substantial, above-average growth rates and have a positive cash flow—stocks of companies whose earnings are increasing at a much faster rate compared to their industry peers.
For example, growth stocks can be technology companies, market disruptors, innovators, businesses in emerging markets, or other rapidly expanding industries with high growth potential. Some examples of growth stocks include large-cap companies Amazon (AMZN), Meta (FB), Netflix (NFLX), or small-caps Range Resources Corp. (NYSE: RRC) or Denny’s Corp. (NASDAQ: DENN).
Opposite of value stocks, growth stocks’ performance is assessed mainly by revenue and sales growth, whereas value stocks are measured by their trading price and intrinsic value.
Watch the video: Growth vs. Value Investing Explained
What is growth investing?
Growth investing is a process of purchasing stocks of businesses growing at a much faster rate than the industry average. The aim is to make profits through capital appreciation rather than dividends or interest – by selling the stocks after they have gone up in value.
Growth investors usually profit through selling after the value has gone up rather than holding to earn passive income. That’s because most rapidly growing companies are re-investing their earnings back into their business to develop new products or services and don’t often have the means to pay out dividends.
Because of this, investors look to maximize their capital gains, which is why growth investing is also known as capital growth or capital appreciation strategy and an offensive investment strategy.
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Offensive vs defensive investing
Growth investing is an offensive strategy that takes advantage of a bull market where stocks and security values rise and outperform. Offensive or aggressive investing is a high-risk, high-reward strategy, focusing on capital appreciation instead of capital preservation. For instance, other high-risk strategies like options and margin trading are also offensive investments.
On the other hand, the defensive investing strategy seeks to reduce the risks of losing the initial investment while still offering a positive return in the long run. For example, investing in bonds, inverse funds, dividend stocks, commodities, or holding cash and cash equivalents in bear markets.
Using defensive investing strategies doesn’t come completely risk-free however it can help to minimize the losses. The focus is on capital appreciation rather than capital preservation or stable cash flow.
Understanding capital appreciation
To fully understand how growth investing yields, let’s briefly explain what capital appreciation and capital gains, and capital preservation is.
Capital appreciation, in simple terms, means the difference in cost between the purchase price and selling price, a process where a stock gains value over time. For example, if an investor buys stocks worth $1,000, over time, they go up and are valued at $5,000 – that $4,000 difference is capital appreciation. If the investor sells those stocks and earns that $4,000, it becomes a capital gain. A rise in the investment’s market price is capital appreciation.
On the other hand, capital preservation is the opposite, focusing on safer and stable, fixed-income investments. The downside is that it usually doesn’t come with as high returns and leaves a risk of inflation.
Growth vs. value vs. income stocks
There are generally two approaches to investing: investors who hope to profit by selling their stocks and investors who intend to invest long-term and collect passive income through dividends. Stocks can be classified into three general categories: growth, value, and income, let’s briefly explain their differences.
When it comes to growth stocks, the business has the potential for capital appreciation over a shorter time. In contrast, value stocks are about finding companies trading for less than their intrinsic value and can grow in the future, a long-term investment.
Growth stocks are more expensive and risky, and their cost is relatively high compared to their actual value. That’s because due to their favorable growth rates, many investors tend to buy and believe they will keep going up in value. The higher risk comes mainly from the fact that if a company’s ambitious growth plans fall through, the prices can also plummet.
Value stocks are generally known as cheaper and less risky, and their trading prices are low considering their actual performance and are selling for less than their intrinsic value. The lower risk comes from the fact that value stocks are usually more stable and established businesses, and there is less risk that these companies fail. However, stocks aren’t necessarily trading for less than their intrinsic value, and the market price might already be correct.
Income stocks pay stable dividends to their shareholders from their profits, offering a steady passive income for its investors. These stocks are also more established companies generating healthy profits and can afford to pay regular dividends – and are good for protecting the portfolio against price volatility.
Growth investing characteristics
Investors should always do their own research before buying stocks to assess the fundamentals and whether they can offer positive strength in the long run. Several main characteristics define growth stocks.
1. Very high earnings growth
An above-average growth rate compared to the industry peers is one of the main characteristics that defines growth stocks.
2. Pay low or no dividends
Growth stocks won’t typically pay out any dividends or pay low dividends or pay them less often, as they continually reinvest everything back into their development to boost the revenues and sustain the high growth.
3. Small or medium-cap companies
Growth stocks are often small-cap or medium-cap companies instead of large-cap stocks. Small-caps have more room for expansion than their larger, already developed counterparts. However, that isn’t a necessary criterion, and also large companies can be growth stocks, for example, Amazon or Netflix.
Small-caps can be high-reward investments as they have more growth potential; however, they also come with elevated risk – due to their early stages and less established operations, there is more that can go wrong.
3. Have a competitive advantage
Growth stocks are businesses expanding faster than other companies operating in the same sector or industry. They often have a unique selling point (USP) as a competitive advantage that differentiates the company from the rest of the market and makes them grow faster.
4. Loyal customer base
Because of their innovations and having a unique selling point compared to the rest of the market players, consumers may prefer them as the first in the market, benefiting from a loyal user base that contributes to growing sales.
For example, suppose a software company develops a new app that isn’t yet on the market. In that case, there is a higher chance it will gain a loyal customer base as first to the market business with that specific service that competitors or other companies aren’t yet offering. It also helps to maintain those customers in the future and keep a large chunk of the market share.
5. Long-term investments
As growth stocks don’t usually pay dividends, investors have to hold their long-term investments to generate sizable revenues through capital gains. Investors can still benefit and make money by selling them earlier but can make double, triple, or even higher fold profits if they hold and sell after several years.
6. High risk investments
Any investing comes with a risk to a certain degree, but growth investing is thought of as a riskier investment than value stocks or income stocks. Growth stocks make an attractive investment opportunity due to their high earning potential and come with a higher risk as the companies aren’t as established as their larger counterparts, and if the company fails to perform, losses may occur.
7. Highly volatile
During a bull market, growth stocks trade at premium prices and are more sensitive to significant value fluctuations making them highly volatile. During economic upswing and prosperity, growth stocks’ prices rise faster than the overall market as investor confidence is high.
Growth stock prices can plummet in bear markets as investors seek to sell high-risk stocks, bringing down the value. What is more, young and smaller companies have a higher chance and risk of going bust.
8. Premium valuation – high price-to-earnings (P/E) ratio
Growth stocks tend to be more expensive compared to the overall market prices with a higher P/E ratio than the industry competitors, as many investors believe in their continued success in the future and invest.
Key metrics to evaluate growth stocks
There is no specific formula to evaluate the potential of growth stocks, as a lot depends on the company and its future plans. For example, how a company will scale their operations, their innovation for new products or services, or how they deal with the high growth, but also on the individual investor interpretation and personal judgment.
However, there are some key metrics and methods to assess the potential, which have to be applied by looking at both objective and subjective factors and keeping the overall company’s condition, including past financial and industry performance.
In general, there are five key things to look out for when selecting stocks that could deliver high capital gains:
Past earnings per share (EPS) growth
EPS is a metric calculated by dividing a company’s profits by its outstanding shares and indicates how profitable the business is. On the other hand, EPS growth refers to how much the EPS has increased over time.
Positive and consistent earnings growth of the previous five to ten years can be an indicator of a growth stock, and how high the EPS should depend on the company’s size.
For example, if a company generates revenues of over $4 billion, EPS of around 6% is good. A smaller company with revenues below $400 million, 12% and above growth is good. So, smaller companies should have higher growth, and for larger companies, it is normal to have a bit lower growth rates.
The general consensus is that if a company has shown consistent growth over at least the past five to ten years, it is more likely to continue doing so also in the future.
Strong future earnings growth
Companies release public statements regarding their financials, plans, and outlook for the next quarter or a year. It also estimates and mentions the future expected growth rates. Investors can check it to determine whether the stocks will grow more than the average compared to the industry and then review the feasibility of the company’s ambitions.
Strong profit margins
Another metric to check is the company’s profitability – its profit margins. Profit margin is a calculation of deducting all expenses from total sales and dividing that number by sales, pre-tax.
It is crucial to consider profitability and not just the growth rate. Even though a company might be doubling its sales, it doesn’t necessarily mean they are also doing it profitably. Low profitability and high growth can reflect that the company isn’t controlling its overhead costs.
However, several successful start-ups aren’t profitable for years as they invest in growth over profits, which should be taken into consideration. Overall, if a business exceeds its previous five-year tax margins and the margins of the industry peers, it shows asset potential.
Strong return on equity (ROE)
Return on equity is calculated by dividing the net income by the shareholder equity. It demonstrates a company’s profitability by showing how much profit it generates with the shareholder investments. It can be a good sign that the management is operating the business well and generating returns from its shareholders’ investments.
Extreme growth rate
For companies to be considered growth stocks, they should at least double their revenues in five years. To achieve this, realistically, the company has to grow by at least 15%, which is quite feasible for newer companies and high-growth industries; anything above that is, of course, even better.
A brief history of growth investing
There are a few notable names related to the growth investing approach. One of them is investor Thomas Rowe Price, the founder of growth investing. In 1950, he set up his Growth Stock Fund, which averages 15% growth.
Another notable name is Philip Fisher, who gave the growth investing method more coverage when he wrote down his investing style in “Common Stocks and Uncommon Profits” in 1958. His book and strategy highlight the importance of research about businesses through networking.
Growth investing risks
Growth stocks are generally thought of as riskier investments due to several reasons. First of all, businesses’ failure rates are higher in growth industries, such as healthcare, technology, or energy.
Secondly, growth stocks tend to be younger businesses with less established operations, which increases the risk of failure. Extreme high growth stocks should also be assertive winners in the industry, but often, this growth is hard to maintain.
Let’s check what causes these companies to fail and what are other main risks to consider before purchasing growth stocks:
As growth stocks are often also “trendy” stocks, investors may be affected by the herd mentality. In investing, it can affect people to base their purchase decisions on the decisions of others and what they are buying, rather than checking the fundamentals. In this behavior, people start acting similarly to those around them without paying attention to their own opinions.
This herd mentality can lead to the overvaluation of stocks, often because many investors think the business can achieve its goals. Once that fails, and the company doesn’t exceed these expectations, disappointing the market, investors may begin to sell, resulting in tumbling share prices and adding to the price volatility.
For example, during the tech bubble from the 1990s to – 2000s, all investors jumped on the technology trend and blindly invested in companies bound to fail.
Execution of future plans
It is important to keep in mind that what the company puts down on paper in terms of their future development plans, such as a new product or service, doesn’t necessarily mean they can execute their ambitious promises. Without these expansion plans, it may not achieve the growth promised to its investors, making growth stocks that much more risky.
Businesses growing fast are at a higher risk of failure if the management cannot handle the scaling of operations well, thus increasing the risk of the investment.
Managing a fast-growing business isn’t easy – going from a company with 100 employees operating in one country to a company with 500 employees and multiple countries can be a real challenge for the management.
Trending products and industries
Companies that disrupt the industry at one point don’t necessarily mean they will be the market disruptors forever. For example, let’s take software company BlackBerry (NYSE: BB) was among the first in the market with their innovative smartphones. Years later, companies like Apple (NASDAQ: AAPL) took over with new products and more advanced technology.
While investing in high-growth companies can seem tempting due to the possibility of earning high profits, a simple thing to look out for is the profitability of a business. Selecting growth stocks that are also already profitable can eliminate or reduce the risk.
Growth investing strategies
Due to its higher risks, growth investing isn’t for everyone, and some may opt for safer and more stable, defensive investing strategies. However, if executed correctly, growth investing can generate marginal profits.
By developing a strategy that is right for you as an investor considering your risk tolerance, one can put themselves in a good position to generate wealth in the long term.
Technology and healthcare, trending industries
Companies operating in the healthcare and technology categories have historically been good opportunities for investors looking to add to their portfolios. One of the main reasons for this is that tech or healthcare industries are known to almost naturally have more disruptive and innovative products and services, solutions, or unique business models, enabling their market dominance.
Businesses developing one-of-a-kind revolutionary products or services often have a better chance of succeeding and generating sizable sales over a shorter period, thus having a higher chance of capital appreciation.
As younger and smaller businesses have naturally higher growth potential, investors sometimes favor buying small-cap or medium-cap stocks instead of large companies. Large-caps have often already achieved their maximum growth and are more established in the market, earning stable revenues.
Also important for growth investing is portfolio diversification to reduce the risk – in multiple stocks, rather than to invest a lump sum in one growth stock. What is more, not just buying multiple stocks only in the tech industry or just in emerging markets, but across several different sectors or markets.
Some of those growth stocks may succeed, some may fail; by diversifying, you can decrease the risk and increase the chances of capitalizing on one of them succeeding and achieving above-average growth in the long run.
Growth exchange-traded funds (ETFs)
If you don’t have time or trust your own research, you can take more accessible strategies and approaches to investing in growth stocks.
Growth exchange-traded funds (ETFs) can be an excellent choice for less experienced investors and are designed to include a variety of stocks displaying rapid growth, where professionals select and manage the fund instead.
Growth investing offers investors the chance to outperform the market as stocks grow at above-average market rates and earn through capital appreciation and capital gains.
However, it also comes with higher stakes and requires a high risk tolerance – excessive growth is hard to maintain, and many businesses end up failing, thus losing money for investors. The key is to maintain a diversified portfolio to reduce the risk of one company failing and the other succeeding by balancing it with different types of stocks and assets.
What is growth investing?
Growth investing involves purchasing stocks that are growing much faster compared to the rest of the market and the industry they are operating in, profits are made through capital appreciation. Usually, businesses in rapidly expanding industries, emerging markets, or companies with innovative products and services.
What are growth stocks' characteristics?
One of the main characteristics is above-average growth, other common traits include: high price-to-earnings (P/E) ratio, low or no dividends, younger companies, businesses with a competitive advantage in the market and the industry, and a loyal customer base.
How to assess growth stocks?
There is no accurate formula, but monitoring metrics like past earnings growth, future earnings forecast, profit margin, ROE, or reading about the future strategic plan, product or services innovation, can help to assess the potential.
What are the risks of growth investing?
High-growth companies tend to have a more elevated chance of succeeding, but they also have a high probability of failing. Extreme growth is hard to maintain – scaling operations, constant innovation, remaining profitable requires a good management team.