Growth Investing

Growth investing is an investment strategy that seeks to buy stocks of companies that are expected to grow at a faster-than-average pace compared to their business segment, industry, or overall market. Investors who adhere to the school of growth investing tend to favour companies that are smaller and younger but having the potential to enhance profitability in the future.

An understanding of what growth investing is important in choosing the right stocks given the fact that stock investing, in itself, is complicated. An incorrect or partial understanding of the strategy may lead to missed opportunities, picking bad stocks, and wrong decision-making resulting in losses for an investor. Let us understand growth investing along with examples, advantages, limitations, and some thumb rules or strategies.

What is growth investing?

A well-known investing strategy among investors, growth investing typically targets companies that show high potential in terms of above-average growth in revenue, profit, or cash flows compared to their business segment, industry, or the overall market. Thomas Rowe Price, Jr. has been called the ‘father of growth investing’. Phil Fisher was another towering figure who influenced the growth investing style.

The objective of growth investing is appreciating capital over the long term. Growth investors only focus on early-stage growing companies that show a tremendous potential for growth. Such companies tend to be innovative, spend heavily on R&D, and introduce products or services that have a unique value proposition in the market. Competitors cannot compete with such growth stocks and ultimately become imitators or move to a new segment.

Also read: What is financial statement analysis

Example of growth investing

Consider two portfolios X and Y consisting of 10 stocks each. While portfolio X contains all growth stocks, portfolio Y contains all defensive stocks. Defensive stocks grow at a pace lower than the overall market but prevents capital depreciation in the case of a bear market. During the bull market phase, portfolio X gave an annualised return of around 26% whereas portfolio Y generated a return of around 7%. Since the general market index gave a return of around 14%, it can be concluded that during phases of market optimism, returns of growth stocks will eclipse the returns generated by the market index.

In the Indian context, Zomato would be a good example of a growth stock. With a current P/E ratio of around 536, it is at a high valuation. According to a research study, the online food delivery market is projected to grow at a CAGR of 24.32% from 2024 - 2032. With a strong YoY revenue growth of more than 60% consistently over the last three financial years, Zomato is one of investors’ favourites. Amazon represents an example of a growth stock in the US market.

Its P/E ratio has always been over 60. Few companies have built strong and futuristic businesses as Amazon and an interesting aspect is that its core business, i.e. online commerce, has experienced operating losses. However, the combination of online commerce, fulfilment centres, last-mile connectivity, and the resulting ecosystem and network effects are difficult to replicate. So, even though growth stocks such as Amazon are available to buy at a high price, growth investors prefer staying invested since today’s price might seem to be at a discount ten years down the line.

Also read: What is solvency ratio

Key takeaways

• Growth investing looks forward to buying companies exhibiting a strong growth potential that beats the industry or the market growth rate

• Growth stocks can generally fall under two buckets - innovative companies and small cap companies

• Small cap stocks are available for buying at a lower price that offers more room for expansion and price increase

• Innovative companies invest heavily in R&D and consistently launch state-of-art products and solutions

• An investor should consider his risk profile before adopting the approach of growth investing

How growth investing works?

In terms of metrics, growth investors focus on strong earnings per share growth as well as revenue, profitability, and cash flow. Efficient use of capital is also keenly tracked in this style of investing. Since rapid growth of stocks is a cornerstone of growth investing, companies that pay high dividends regularly are not preferred by investors. Instead, companies which reinvest most of their profits into the business are the favourites of growth investors.

The word ‘potential’ holds a lot of weight in growth investing because a growth stock may not exhibit profitability currently but has a high growth potential. As such stocks are in a high-paced growth trajectory, investors do not mind paying a premium for the stock which is in contrast to value investing that advocates buying fundamentally strong companies below the intrinsic prices.

Growth investing is an extremely risky strategy and investors need to have a lot of conviction in the stocks that they choose. A careful research of the business segment, industry, product life cycle, company life cycle, key growth metrics, company management, and customers is essential for growth investing to be successful.

Compared to defensive stocks and value stocks, growth stocks tend to generate better returns in a bull market. However, growth stocks are prone to market dynamics and when market sentiments are negative, growth stocks can generate negative returns as well. So, this is a high-risk high-reward strategy.

Strategies for growth investing

The following strategies serve as key in choosing good growth stocks:

• Previous earnings: Historical returns generated by a stock indicate what has been the company’s trajectory. Typical growth stocks exhibit tremendous growth in earnings over the past 10 years.

• Stock price trend: As an investor, you need to keep a tab on the current performance of the stock price. A growing company in a growing industry will never take 15 years to double its stock price.

• Growth prospects: The industry or the segment in which the company operates should be a growing one. Also, the company must have the potential to beat market and industry growth in the long term.

• Peer benchmarks: The company should be growing at a rate higher than that of its peers. None of the peers should be able to achieve a growth rate that is near the company’s growth rate.

• Return on Equity: If the company is generating a good return on equity for the capital invested, it is an appropriate candidate for a growth stock. This shows that the company is efficiently allocating the money invested by stockholders. Companies that display a high Return on Equity compared to the industry average are good contenders for growth stocks.

• Profit margins: A company should be currently profitable or exhibit a strong potential of turning profitable in the future. Strong revenue growth coupled with losses signifies that the company leadership is not able to manage the costs.

Also read: What is leverage ratio

What are the characteristics of growth stocks?

1. High-growth industries

Growth investing happens for industries that are expected to grow faster than other industries. Examples of such high-growth industries in India could be online food delivery, fintech etc.

2. Economies of scale and competitive advantages

Companies that exhibit high economies of scale and competitive advantages are good candidates for growth stocks. Competitive advantages could be brand value, pricing power, unique technology, patents, strong network effects, and high switching costs.

3. High price-to-earnings ratios

As an investor, you need to choose stocks that have a higher price-to-earnings ratio which signals that the market places a premium on such stocks.

Advantages of growth investing

1. Potential for high returns

A major upside of growth investing is that investors can enjoy higher returns by investing in growth stocks. High-growth companies typically experience a rapid increase in their stock prices that translates to more returns for the investors.

2. Diversification

Growth investing offers you the opportunity to diversify your portfolio and hold stocks of rapidly-growing companies in high-growth industries. This can reduce the overall risk associated with stock investing.

3. Inflation protection

Growth stocks with high growth potential usually see an increase in stock prices during periods of inflation, and therefore, they shield an investor from the downsides of inflation.

4. Potential for capital appreciation

A fundamental objective of growth investing is capital appreciation and investors can experience a higher capital appreciation for growth stocks in the long run. This is because growth stocks outperform other types of stocks in terms of growth rate.

Disadvantage of growth investing

As an investor, you must be aware of the disadvantages of investing in growth stocks. Since it is a very risky investing strategy, you should diversify and keep in mind the following limitations of growth investing:

1. High price-to-earnings ratios

A higher price-to-earnings ratio, i.e. P/E ratio, represents that the market overvalues growth stocks. The valuation of growth stocks can change with market cycles. If an investor invests in a company and the company does not meet growth expectations, he is likely to lose money on his investment.

2. Volatility

Volatility is a key drawback of growth stocks because of the stock price variation resulting from market swings. This volatility makes the task of forecasting the returns over the short-term extremely difficult.

3. Dependence on future growth

The probability of growth investing success rests on the potential growth of the company in the future. If the company fails to perform as predicted or performs at a slower pace, then the stock price plunges and investors can lose money.

4. Limited dividends

Growing companies prefer to reinvest profits into their business operations and provide dividends less frequently. Therefore, growth investors cannot receive regular income from growth stocks as in other types of stocks.

5. Potential for high valuation

A high P/E ratio indicates that growth stocks are overvalued by the market and the investor needs to pay a premium. Paying a higher price means that the investor has to take additional risk in order to generate substantial returns.

You should be aware of the above drawbacks before choosing growth stocks. If you are not keen on taking high risk, it is better to have a limited number of growth stocks in your portfolio.

Also read: What is profitability ratio

Rule of growth investing you should keep in mind

1. Look at P/E and PEG ratio

The P/E ratio indicates the market valuation for a particular growth stock. Usually, growth stocks have a high P/E ratio which points to the fact that investors are willing to pay a higher price for the stocks due to its growth potential. However, a high P/E ratio could also result from a bull market or a period of inflation. Therefore, to account for these factors and evaluate a company’s true financial position, a PEG ratio, i.e. the price-earnings growth ratio should also be looked at while evaluating a growth stock. The company’s EPS is factored in by the PEG ratio.

2. Look at growth in sales

A consistent increase in YoY and QoQ in sales indicates that the company is launching new products, acquiring new customers, and expanding into other business segments. A growth stock should display these characteristics.

3. Focus on company’s EBITDA

EBITDA, or earnings before interest, taxes, depreciation, and amortisation, indicates a company’s ability to derive profits from its core business operations discounting external factors. A growing company should have increasing EBITDA and a consistent EBITDA margin.

4. Look at the growth in net profit

A consistently growing net profit signifies that the company is able to generate profits after factoring in cost of business operations and cost due to external environment. This proves that the company has developed a customer base who are buying its products and services.

5. Track earnings per share

A growth stock should typically exhibit a higher earnings per share (EPS). A historically high EPS suggests that the company will be able to sustain its growth in the future as well.

6. Watch out for earnings announcements

Earnings announcements provide investors valuable data on whether the company has been able to beat the estimates or has missed those. A growth stock should be able to consistently beat those estimates.

7. Diversify your stock portfolio

As an investor, you should never have a concentrated portfolio but instead diversify among other types of stocks apart from growth stocks. Even with growth stocks, you have to diversify across industries and business segments.

Conclusion

Growth investing is essentially a high-risk, high-reward strategy, and therefore, it is extremely critical to hedge against investments in growth stocks. Investors with a higher risk-taking appetite can follow growth investing. A prudent way of reducing risk of investing in individual stocks is to invest in growth-oriented mutual funds and exchange traded funds.

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