How Growth Investing Works
As the name suggests, the focus of growth investing is growing an investor’s capital. Investments are made in types of instruments known as growth stocks or through investment in companies which are identified as likely to grow their earnings at a rate that is considered above average for the market and/or the industry.
Growth investing is often referred to as a capital growth strategy as capital gains are the aim of the investors. However, this is not always how the strategy is viewed. Some say that value investing and growth investing are opposites. Value investors are on the lookout for stocks which have an intrinsic value above the level at which they are trading, while growth investors will turn a blind eye to standard indicators which may indicate that a stock is overvalued.
Growth investors will seek stocks in emerging companies which they see as having the potential to take off and evolve into large powerhouses and, if successful, such stock picks can bring impressive returns – and everyone is looking for the next big online start-up or breakthrough invention. This strategy, however, is high-risk, as it brings the potential to invest in companies that never take off and just fade away.
Defining Growth Stocks
Put simply, a growth stock is any share in an organisation which is expected to grow its earnings at a rate which exceeds the market average growth rate. They are usually not shares which pay dividends as growth-oriented share models will divert extra profits into the business in order to grow aspects such as capital projects.
A good example of growth stocks would be technology companies, as the potential for growth in this sector is practically limitless. Conversely, this kind of stock carries greater risk because capital gains are dependent on the company’s success in the business world. Should the business fail for any number of reasons – for example:
- Competitors gaining an advantage
- Marketing not being as effective as expected
- Demand for the product falling away
Any of these things happening would likely cause shareholders to experience losses as share prices fall in line with confidence.
While small-cap stocks are often the prime type of growth stocks, not all growth stocks come from small-cap companies. Growth stocks can be those which are based on scale of manufacturing. Mass production methods make unit prices much cheaper than smaller scale operations, so large companies which are taking advantage of the economics of scale can be a ready source of growth due to the profits such a model returns.
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Size Doesn’t Matter
There are a few other features that all growth stocks share regardless of the size of the company. A growth company will either have a strong grip of the market share in its sector or enjoy a customer base with a strong sense of loyalty to the brand or product. This may be because it was the first company to provide a service or product of that kind or that it has a strong reputation for being the best “go-to” in that market segment. A unique position or niche within a sector is a common factor for growth companies and can even be the defining feature.
Growth companies tend to have specialised, unique, innovative or advanced products on offer. Perhaps they hold a patent on an invention or innovative technology. They may dominate a field of research or advancement for a specialised industry. These factors are the same ones that dictate the reason that these kinds of operations do not follow the dividend model. If you are at the cutting edge of a field of research, and profits made need to be re-invested in research and development, diverting money into dividends would only serve to hinder the very advancement that is causing the company to grow.
Assessing a Company’s Suitability
The goal of a growth stock investor is to correctly identify stocks that are either undervalued or merely at a low value but with high potential to grow after emerging. Making such a call is a matter of both subjective and objective judgement on the part of each individual investor and will be dependent on a combination of their knowledge, instincts and life experience. Each individual investor will have a decision-making process that best suits their investment strategy, how much they have to invest and their investment objectives. In addition to the individual investor’s own knowledge, they will usually look at where the company places within its industry and how it is performing, as well as the company’s past performance in the relevant industry. Things to note are:
- History of the company’s earnings growth since it was founded
- Estimates for forward earnings growth, usually outlined in the most recent company reports
- How well the management is controlling costs and revenues
- The manner in which the management operates the business
- Whether there is potential for the company to double in value within five years
These are the five factors which will usually have the most influence over an investor’s decision when rating an individual company.
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Assessing Growth Against Value
Looking a little deeper into growth investing, there are two related but distinct types of stocks: true growth stocks and value stocks. Value stocks are those which have the potential for growth due to their being undervalued or underrated. These stocks will be seen as having the potential to create strong capital gains but for one reason or another the market has ignored or underrated them. They are called value stocks because they are undervalued.
The other type of growth stocks are those which have already been identified by the market as having the potential for growth. The problem this creates is that since they are known to have growth potential, they are overvalued, which means growth is a slower process.
So ideally, value stocks are the best ones to look for. They may have issues such as a past record of flat earnings results, legal issues or bad press, but are useful provided you can identify solid fundamentals, decent financial structure and a history of solid overall performance. It is consistency that can be an indicator of good future performance because as a company finds its feet, earnings will start to grow. As long as the company hasn’t been posting persistent losses it is worth looking into.
The best overall strategy is to diversify your portfolio and hold a combination of value stocks and growth stocks to create well-rounded trading strategies.
Look for Trending Sectors
This section of our growth investing guide will cover the art of seeking out hot sectors on which to concentrate. It is reasonably easy to identify the popular sectors. Reading the financial press is a good indicator, as the trending sectors will be the ones that are being written about the most across multiple publications. Always check multiple news agencies for these trends – don’t base your research on just one source.
Keep reviewing which sectors are the movers, as like all trends, this will change over time. What is hot one year may very well have fallen out of favour the next and it is important to check in continually on how your picks are faring. Be prepared to change what stocks you are backing if need be.
For example, healthcare and pharmaceuticals have been strong sectors in the past decade or so, as have tech companies, either web-based businesses – everyone has heard of dotcom stocks – and also the kind of tech companies that produce software and hardware for commercial applications. These are sectors that grow along with advances in technology, and the tradition is that as technology develops, prices for existing technology comes down, enabling more economical use of that technology to create even more advanced technology, so these type of companies have a cumulative effect of driving their own sector. This is a recipe for success in a world that is becoming ever-more technologically reliant.
Using Exchanged-Traded Funds and Other Derivatives
Growth investing can be simplified with the use of pre-packaged investment vehicles which are created by investment banks or fund management companies. These can take the form of exchange-traded funds (ETFs), mutual funds, mortgage-backed securities and other types of derivatives.
The advantage of this kind of security is that all the research and hard work is done for you. If you become a client of a provider of such products, you are usually able to discuss your requirements with a financial advisor who is essentially a salesman for the company’s investment vehicles. Advisors are there to identify the type of investment strategy you are looking for and match those requirements with the products they have on offer. Depending on the company, this can incur separate broker fees, but in some cases the fees are built into the prices of the instrument. For example, ETFs are popular due to the fact they can be packaged up with low trading costs.
- An ETF is a tradeable bundle of stocks
- They are a convenient pre-packaged portfolio
- For a fee, much of the hard work is done for you
It is important to remember that ETFs are not an easy answer. Just because a company has packaged up a basket of stocks which trade like a single stock, it doesn’t mean they can’t be hit by a volatile market. The possibility of large swings in value of course depends on the underlying assets and this will vary between individual ETFs.
While it is a long-term strategy and not a get-rich-quick scheme, growth investing is one of the riskier and more volatile of the stock investing strategies. Choosing the right stock involves a great deal of research and insight into what kinds of companies – particularly start-up companies – are likely to become the next Google. Investors need good business sense and the ability to understand company earnings reports to be able to make educated calls on which stocks are worth taking on board and which are in danger of collapse. There is no foolproof formula and success can be as much the result of luck or circumstances that could not be predicted as the result of skills and ability on the part of the investor.
There is a certain amount of satisfaction that comes from sniffing out an undervalued company, investing, watching it grow, then when it powers ahead, being able to say that you found it before anyone else knew how big it was going to be.
When taking on this kind of strategy, decide how you are going to structure your portfolio and what sort of timeframe you have for investing, and then do your research and keep up with the markets. Taking an active role in the management of your investments will go a long way to ensuring only successful company stocks remain in your portfolio over the long term.