What is Growth Investing?
There are many different investing philosophies out there. One of the prevailing strategies for accumulating wealth is through growth investing. This investment practice focuses on stocks with quickly growing earnings, anticipated to continue growing in the future. These companies tend to be small-to-medium-cap companies that are industry disruptors. Their ability to carve out a niche and capitalize on previously untapped demand positions them for rapid and often long-term growth.
Disruptors aren’t the only growth stocks out there, however. Many stocks enter a period of growth as they launch a new product or participate in mergers and acquisitions. The company itself doesn’t always matter to the growth investor—its earnings trajectory does. Here’s what growth investors are looking at as they seek to build wealth.
Growth Investing: Where to Find Growth Stocks
When searching for growth stocks, there are certain sectors prone to them—and others less welcoming to growth stocks. Technically, any budding company that’s outperforming the sector on a sustainable trajectory can be a growth stock. That said, here’s where investors most often look for growth stocks:
- Tech sector and other industries prone to offer disruption
- Emerging markets, where economies are less established
- IPOs, SPACs or other public debuts for startup companies
- Spinoffs, mergers or acquisitions, where synergies form
Growth stocks often have a lot to do with demand on a macro scale. Depending on social demand, companies may find themselves on a growth trajectory, even if they don’t fit into one of the categories listed above. For example, NVIDIA Corporation (NASDAQ: NVDA) has been public since 1999; however, its share price has grown more than 1,300% over the past five years due to the explosion of cryptocurrency mining. A former middle-of-the-pack company, NVIDIA is now considered a growth play.
Growth Stock Indicators
Growth stocks stand poised to grow faster and more sustainably than their peers. And while it’s impossible to predict the future, it is possible to gauge the performance of companies and trajectory metrics. Here are some of the chief indicators investors look at to identify a potential growth stock:
- Historical earnings growth. Have the company’s previous earnings outpaced average?
- Future earnings growth. Is aggressive earnings growth expected to continue on?
- Profit margins. Does the company have healthy profit margins and sales growth?
- Returns on equity (ROE). Is the company maximizing the efficiency of its assets?
- Share price performance. How has the share priced performed vs. book value?
Another telltale sign of a growth stock is one that’s priced well-above earnings or book value. This indicates that there’s strong sentiment for growth and outperformance. Investors willing to pay a premium to own shares of a stock do so because they believe future earnings will justify that premium. Buying now, even at a premium, puts these investors in a position to capitalize on long-term growth.
Growth investing is one side of the investing coin; it’s opposite is value investing. While growth investors look for companies poised to outperform their peers with rapid gains, value investors look for underpriced stocks and hold them long-term. While growth investors have no problem paying a premium for the promise of future gains, value investors rarely ever pay more than book value for a stock if they can help it.
The big difference between growth investing and value investing is timing. Value investors want to capitalize on the best price of a stock today; growth investors look ahead to the potential of a stock far into the future.
The Benefits of Growth Stocks
Growth investing offers significant return on investment when executed appropriately. Capitalizing on a stock with a long runway for growth will return many multiples to investors over the long-term. There are a multitude of recent examples of growth stocks returning significant wealth, including Amazon (NASDAQ: AMZN), Netflix (NASDAQ: NFLX) and Shopify (NYSE: SHOP).
The biggest benefit of growth investing is the ability to capitalize on a company’s early-stage efforts and reap the long-term results of its growth. There’s a higher risk-reward factor, but many investors agree that the reward outweighs the risk substantially. The expectation is that a growth stock will return many multiples over the course of 5, 10, 15 years or even longer. In fact, if a growth company begins to offer a dividend, it could even become a dividend growth stock.
The Drawbacks of Growth Investing
Investors pursuing a growth investing strategy need to prepare for volatility. Burgeoning companies—especially those moving fast—can have hit-or-miss earnings reports. Moreover, they’re often burning cash quickly to grab market share. Cash rapidly coming into and going out of the business takes its toll on investor sentiment. Share prices can rise and fall wildly, spiking high and dipping low in times of particular turbulence.
The prospect of finding a growth stock is also difficult. These companies tend to be diamonds in the rough when they pan out. Growth investing demands the same patience as value investing, with strong technical and fundamental analysis skills. Investors need to be confident in their growth stock picks and hold them long enough to capitalize—or know when to cut losses.
The Bottom Line
Growth investing is all about looking ahead to the future. And while you can’t predict the future, growth investors are more than willing to take a chance on the current trajectory of a well-performing company. Its balance sheet might not look the greatest today, but if it has strong earnings growth, good margins and efficient return on equity, there’s a real chance it could be at the top of its industry in just a few years’ time. If the signs are there, growth investors are willing to take that bet and reap the returns that come with it. To discover the latest stock trends and investment opportunities, sign up for the Trade of the Day e-letter below. The team at Trade of the Day does the research for you and provides invaluable insights for investors of all experience levels.