What Are The Best Characteristics Of Good Growth Stocks?
For long-term investors, this could be one of the best times over the past decade to invest in growth stocks. Right now, most major indexes are down around 20%. Many growth stocks are down over 50%. The valuations for many exciting companies are looking more attractive by the day. Of course, there is no telling how long the current bear market will last. It could be several more months before things start to turn around. However, it’s still a good idea to identify potential growth opportunities that you want to buy. This way, when the market turns around, you’ll be ready. With that said, let’s examine the best characteristics of good growth stocks.
Best Characteristics of Good Growth Stocks
Long-Term Business Potential
One of the most important characteristics of good growth stocks is the viability of the business model. In other words, does this business sell a product or service that’s valuable, and will it continue to be valuable in the future? If the business is successful then the stock will surely follow. But, if the product/service is easily copied or not valuable then the stock could suffer.
In most cases, this is more of a critical thinking exercise than anything else. Since nobody can predict the future, there is no way to definitively say if a business will succeed or fail in the long term. But, it’s possible to make an educated guess based on data and a thesis. Oftentimes, two different investors will have vastly different opinions about the future of the same business.
For example, one investor might be incredibly excited about the future of sports gambling. This investor thinks that sports gambling will inevitably be legalized at a federal level and turn into a massive market. For this reason, the investor is loading up on DraftKings stock. But, a different investor might think that the path to legalization will take far too long. It doesn’t matter how popular sports betting is. If it never becomes legalized then DraftKings will never make any money. For this reason, the second investor is staying far away from DraftKings stock.
One of the best ways to determine if a company has long-term potential is to examine its competitive advantage.
What’s a Competitive Advantage?
A competitive advantage is something that sets a company apart from its competition. Without some sort of advantage, a company will never be able to excel. Here are a few examples of businesses with major competitive advantages:
- Google has been indexing the internet for decades. It has a massive head start on this that makes it nearly impossible for newcomers to catch up.
- Facebook has around 3 billion monthly users. For years, this size advantage made it hard for other new social media companies to gain traction.
- Tesla is run by Elon Musk. Musk is one of the most visionary founders of our generation. His expertise and guidance give Tesla an advantage over other automakers.
A company’s competitive advantage could be just about anything. It could be a design patent, management team, experience, unique operating procedure, a beautifully designed app/website, high-quality customer service, a unique new business model, etc.
The most important thing is that the advantage is not easily copied. If the business model can be easily copied then it probably will be. One example of a business that didn’t have a sustainable competitive advantage was Bird Scooters. Granted, the idea to put electric scooters on sidewalks was very unique. But, Bird had no way to prevent other companies from copying it. These days, there are dozens of different electric scooter companies. Except for the logos, all these companies are pretty much the same. Subsequently, Bird stock is down over 90% since going public.
Now, let’s jump back to the other best characteristics of good growth stocks.
A Large Market
The best growth stocks are companies that tackle large markets. A company’s market is the total number of potential customers that it can serve. This is also sometimes called a company’s “total addressable market” or TAM.
An example of a company with a massive total addressable market is Uber. Uber’s market is anybody that requires transportation. If you’ve ever had your car breakdown, gone to the airport, or taken a night out on the town then you’ve had a need for Uber. This is part of the reason why it posted a 2021 annual revenue of $17.46 billion (Granted, Uber’s got a few other problems with its business model but that’s a topic for another article).
Compare Uber’s TAM to a company like Wheels up. Wheels Up is a marketplace that helps people charter private jets. Millions of people can swing $10-$20 for an Uber ride across town. But, not many people have a spare $10,000+ laying around to charter a private jet. For this reason, Wheels Up has a much smaller total addressable market than Uber. In fact, Wheels Up really only serves about 10% of the country (if that).
Keep in mind that a company with a small total addressable market can still be successful. But, in general, companies that serve larger markets have more potential to grow.
Perhaps one of the most important financial characteristics of good growth stocks is increasing revenue. Increasing revenue signals a few things. First, it means that there is demand for the company’s product/service. Second, it means that the company will have more money to invest in its business.
For growth stocks, higher revenue means that the company can hire more employees, open more offices, and design more products. Most of these initiatives almost always directly lead to more growth. For example, if a company has high revenue then it can hire more salespeople. With a bigger sales team, the company will probably sell even more product next year. This means that it will be able to open another office, hire even more salespeople, and so on…
This is why investors focus mainly on revenue during earnings reports (along with earnings per share). However, simply making more money isn’t enough. Companies also need to successfully invest this money back into their business.
Monitor Corporate Decisions
As mentioned, there are dozens of ways that a company can invest back into its business. However, as the investor, it’s your job to ensure that the company is making good investment decisions.
One way that you can do this is by checking out the company’s investor presentations and annual/quarterly reports. These documents will tell you how the company is spending its money (to an extent).
It’s important to remember that companies don’t always make the right decisions. After all, companies are run by people and people are far from perfect. One example of a CEO that took misguided steps is Adam Neumann of WeWork. WeWork was a high-growth stock back in the 2010s. But, Neumann funneled company money on things like lavish company retreats instead of initiatives that would grow revenue.
This is an oversimplification of WeWork’s story and I’d recommend watching one of the documentaries on the story. It’s fascinating stuff.
Speaking of Adam Neumann and CEOs, let’s take a look at one of the last characteristics of good growth stocks.
Investing in Growth Stocks
At the end of the day, a company is made up of people. The decisions and ideas formulated by these people are what ultimately lead to higher sales, revenue, and stock prices. If you have the best people in your company then you have the best chance of succeeding. This is why, when discussing the best characteristics of good growth stocks, a strong leadership team should always be at the top of the list.
One thing to look for in younger companies is whether or not they are still led by their founder. In general, founder-led companies tend to perform better than companies where the founder has moved on. A few examples of larger, founder-led companies are Tesla, Meta Platforms, Netflix, and Amazon (until just recently). This is usually a common trend because founders are incredibly passionate about their business. They have an intrinsic motivation that inspires them to work longer and harder than their competition.
I hope you’ve enjoyed learning about the best characteristics of growth stocks! Please remember that I’m not a financial advisor and just offer my own research and commentary. As usual, please base all investment decisions on your own due diligence.