Growth investing is a financial market strategy to build capital wealth by focusing on assets capable of achieving above-average expansion in the future. This market approach centers on the performance of growth stocks, which are typically categorized as small-cap companies with above-average earnings projections (relative to the industry sector as well as the broader market).
The ability to successfully buy into a young company in its earliest stages of growth is a skill that can generate impressive returns if the business is able to deliver on its expectations. This central reason growth investing is particularly interesting for many investors. However, many of these companies are new and untested, so there are risks present which might not be associated with more traditional forms of long-term investment strategy.
Typically, a growth investors will seek out investment opportunities in markets or industries which are ready to show rapid expansion. Oftentimes, new services, products, or technologies are being adeptly developed. These growth investments aim to capitalize on emerging earnings profitability and generate capital appreciation in the process. In simple terms, “capital appreciation” refers to the gains an investor will receive after the stock rises in value and the equity position is sold.
As opposed to investments in dividend stocks (which generate peripheral returns), growth investment strategies require capital gains in order to achieve profitability. For the most part, companies in the growth-stock category won’t offer dividends to shareholders because this money needs to be used to reinvest back into the core businesses. This is the fastest way for earnings growth to occur in any company’s earliest stages.
Growth companies tend to be young businesses of smaller size (with stocks that have only recently been made available for trade on public exchanges). However, these can also be stocks with the most upside potential (for capital appreciation) in all of the financial markets. The chart below offers a comparison of industry categories and their relative growth/dividend rates. Consider the strong growth trends seen in the information technology, consumer discretionary, and healthcare industries:
With these trends in mind, the central idea of growth investing is that a new company will be able to expand and prosper in ways that are simply not possible for large, mature companies. This enhanced potential for growth in revenue and earnings eventually translates positively and produces stock price rallies in the future. Investors are always interested in maximizing the potential for capital gains, so strategies involving growth investing might sometimes be referred to as “capital appreciation” or “capital growth” strategies.
When assessing a company’s potential for stock growth, an investor might first look at the market or industry that is most directly relevant to its performance. Does the potential for growth in the consumer market even exist? Does the company have a product or service that is truly unique and likely to gain traction within a large population demographic? Of course, there’s no guaranteed formula that can be used to evaluate a company’s true potential for growth. All possible calculations require a certain degree of interpretation, but assessments based on objective factors and subjective judgment can often yield favorable results.
Growth investors can use specific criteria as a framework when conducting stock analysis. However, any metric-based fundamental analysis method needs to be viewed in conjunction with company-specific factors in mind. Investors must have a broad understanding of the situation vis-a-vis historical financial performance within the context of the past (and future) industry outlook. When selecting companies to use as an investment vehicle for growth investors to achieve capital appreciation, consider these five financial metrics:
From each of these characteristics, we can see that growth investors aim to build wealth through short- and long-term capital appreciation. When compared to value investing, the returns present in growth investing strategies have presented some impressive returns over the last 25 years:
During strong market periods (i.e. the 1990s) growth investing strategies outperformed value investing strategies by a healthy margin. This trend reversed during the tech bubble market crash of 1999-2001, which is not surprising given the large number of technology stocks that fall into the growth stock category. However, during the larger market crash of 2008-2009, value investing stocks were actually hit much harder (with losses that outpaced growth stocks by a wide margin).
Some market analysts consider value investing and growth investing as diametrically opposed strategies. Value investors tend to focus on stocks that are currently trading below book value or at a discount relative to the intrinsic value of the company. On the other hand, growth investors tend to ignore stocks with lower (or sub-standard) financial metrics. While growth stocks investors aim to conduct a broad analysis of the fundamental worth of a company, these investors often have no problem buying into a stock position that a value investor might consider to be overvalued.
The central difference is that value investors seek stocks trading at levels that are below intrinsic value, which is why many in the market will often refer to the strategy as “bargain hunting.” In contrast, growth investors are more focused on the forward outlook and future earnings potential of a company (rather than current share prices). This means growth investors might consider buying stocks that are actually above current intrinsic valuations (based on the assumption that the company’s intrinsic value is still in its earliest phases and likely to grow far beyond current valuations).