Investing in Growth Stocks
For many investors, the holy grail of investing is to find a growth company early on its path to greatness, hang on as its revenues and earnings rise sharply, and then reap big rewards as other investors climb aboard. That is what growth stocks such as Apple, Amazon, Facebook, and Google have done for investors over the last several years.
A growth stock represents shares in a company with earnings growth that is expected to outpace the average earnings of the market.
It could be a small company that has introduced a ground-breaking technology, or it could be a larger company that has achieved a competitive advantage in a growing market. Larger companies that achieve economies of scale in their manufacturing or production can often keep more of their revenues as profit, which can accelerate their growth.
In either case, the company seeks to grow its profits by reinvesting its earnings into capital projects that can increase its earnings at a faster rate than its competition. That is what attracts growth investors who are willing to forgo current income from stock dividends for the opportunity to achieve capital gains. The more investors the company can attract, the higher its stock price will rise.
However, investing in growth stocks can be riskier than investing in other types of stocks, such as value or income stocks. One reason is they tend to be more expensive. Growth stocks typically have high valuations as measured by their price-to-earnings or price-to-book value ratios. That means their stock prices are often high relative to their revenue or profits creating higher expectations from investors for higher sales or profits in the future. If those expectations are not met, the stock’s price could plummet.
You’ll often see comparisons between growth stocks and value stocks as an investment strategy. Both have the potential to improve portfolio performance, but they do it in different ways.
Whereas growth stocks tend to be overvalued and can be more volatile, value stocks are thought to be undervalued and more stable performers. Value stocks are generally larger and more established companies with steady and predictable business models that achieve their gains more modestly over time. They are often identified as companies whose stock prices are trading below what analysts believe the stock is worth. For example, a company’s book value could be pegged at $30 a share, but its stock may be trading at $25 a share. If the company has solid fundamentals, it could be a good “value play.”
Value stocks are attractive to investors looking for consistent dividend growth and who prefer more stable performance. As to which type of stock can perform better over the long term, they both offer upside potential. During strong markets, growth stocks can outperform value stocks, but value stocks tend to perform better than growth stocks during weak markets.
Because it’s difficult to know when growth stocks will outperform value stocks and vice versa, many investors choose to include both growth and value stocks in their portfolios as a way to diversify and smooth out volatility.
Finding the right growth stock opportunity in a universe of more than 100,000 companies with listed stocks can be an extremely daunting task. Where do you start? Maybe you have some companies you’ve been following. Perhaps you have an interest in particular products, industries, or sectors. If you have been thinking about specific attributes you want to see in a company, you can narrow your focus quickly.
There are a couple of ways to do this.
Search the internet: The internet has leveled the playing field for average investors who now have access to the same amount of information once only available to investment pros and institutions. With simple search keys such as “top companies in AI,” or “most profitable companies in environmental, social, and corporate governance (ESG), or “consumer staple companies with exposure to emerging markets,” you will have access to investment blogs, stock analysis articles and financial news for ideas on companies in that space.
The downside is that consuming information from internet searches can be like drinking from a firehose. It’s essential to be critical of everything you read and analyze both sides of the story.
Scour ETF holdings: If you’re looking for companies in a particular sector or industry, find exchange-traded funds that invest in them and look through their holdings. For example, if you want to focus on technology companies, you can use the search key, “technology ETFs.” Go to the ETF’s website where you will find a list of its holdings.
Use a stock screener: You can use a free screener such as the one available through Yahoo! Finance to find stocks based on very specific criteria. The screener allows you to select filters such as region, market cap size, stock price, sector, and industry. You can then drill down further with such specifics as a 52-week trading range, earnings history, debt ratio, price-earnings ratio, and dozens more. Once you have selected your parameters, the screener provides a complete list of results.
When you’ve identified some potential candidates, you can narrow down your search using a number of criteria, such as:
Look for megatrends: Where are the major developments that will have significant implications for the future. Look for solid companies in growing industries, such as biotechnology, digital communications, streaming entertainment, cloud services, or other emerging technologies.
Compare a company’s growth to the industry: Look at a company’s earnings growth over three to five years and compare it to other companies in the industry. If its earnings growth consistently exceeds the industry average, it’s a growth stock to consider.
Look for companies with wide moats: Companies with strong brands, strong market positions, and many intangibles (i.e., patents, innovations, distribution systems) are more impervious to competition or new entrants in the market.
Look for companies with solid management: Does management make smart decisions about investing the company’s earnings? Are they investing for earnings growth, or are they just trying to get bigger through acquisitions?
Proceed cautiously with headline stocks: High-flying stocks like Facebook, Netflix, Alphabet, and Amazon are tempting, but buying “headline” stocks just because they’re hot is like trying to jump on a moving bus. You’re more likely to faceplant than get to your destination. Better to look for growth stocks that are flying under the radar that haven’t yet attracted the attention of the investor masses.
Investing in growth stocks is not for everyone. They tend to be more volatile, and because they can become overvalued, they’re susceptible to steep price declines. But, for investors with long time horizons and the ability to ride through several market cycles, growth stocks have the potential for significant gains over time.
You may be a growth stock investor if:
You can put in the time: Picking the right growth stocks takes a lot of time and effort to do the necessary analysis and due diligence.
You don’t care about current income: Most growth companies don’t pay dividends, preferring to reinvest their earnings into their business to generate faster growth.
You don’t mind wide stock price swings: Growth stocks tend to overreact on the upside when things go better than expected and to the downside when they disappoint.
You have an extended time horizon: Important to mention again. If you think you’re going to want your money back within a few years, you probably should avoid investing in individual growth stocks.
You have enough money to diversify. It isn’t easy to pick the one winner out of hundreds of stocks. Better to buy several growth stocks of companies of varying sizes from different industries.
While there will always be growth stock opportunities in the market, having a long-term investment horizon with a diversified portfolio strategy is the key to achieving positive long-term returns.
Alternatively, if you don’t have the time or resources to search, study, analyze, and monitor individual growth stocks, you can invest in stock index funds that track them. For example, the Vanguard 500 Growth ETF, iShares Russell 2000 Growth ETF, and the Invesco S&P 500 Pure Growth ETF are just a few of many low-cost exchange-traded funds that invest in growth stocks. The benefit of investing in index funds or ETFs is they tend to be less volatile than individual stocks because they provide instant diversification, spreading the risk among dozens or hundreds of stocks.
Dechtman Wealth Management, LLC is a Registered Investment Adviser. This is solely for informational purposes. Advisory services are only offered to clients or prospective clients where Dechtman Wealth Management, LLC and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Dechtman Wealth Management, LLC unless a client service agreement is in place.