There are many different investment strategies to choose from. Growth investing is one of the more popular ones. It’s the most obvious strategy based on its goals. You guessed it…growth, specifically, growing companies. It follows that growing companies tend to outperform the market, but not every growing company qualifies.
What is Growth Investing
A growth investing strategy looks for companies with consistent, above average earnings and revenue growth. In turn, growth investors are willing to pay a premium for a stock now, because they believe the company will grow faster in the future. This leaves growth companies with a higher P/E ratio. Basically, growth investors are willing to pay a higher price (P) now, for long-term future earnings growth.
Growth investing looks for companies in the growth phase of its business cycle. This is usually associated with small cap stocks going through a big expansion and growing faster than the overall market. But it can just as easily be a mid or large cap company.
The best, recent example is Apple Inc. (AAPL). Apple’s first big growth happened in the ’80s and only lasted a couple of years. It wasn’t until 2003 that it hit its biggest growth cycle. Apple went from a $5 billion market cap in ’03 to over $600 billion market cap when it peaked in ’12.
So what do growth investors look for in a stock? Most will start with these metrics:
- P/E Ratio – above average
- Price/Book Ratio – above average
- Return On Equity – increasing ROE
- Earnings Per Share – minimum 15% EPS growth rate
Ultimately, it boils down to future growth and how much you’re willing to pay for it. And that is the tricky part. Future growth is based on forecasts and estimates. While a growth investor will pay more for a growing company, how much is up for debate. By paying a higher price, you’re basically saying the company will continue its above average growth rate over the long-term. But what if your growth estimates are wrong?
The problem is when you overpay for a stock and the company reports a bad quarterly earnings. You see this happen in tech stocks often. At the first sign of slowed growth, the growth investors flee, the stock price tanks, and anyone left is sitting with a loss. So knowing when to sell becomes just as important as knowing when to buy. This is why many investors take advantage of diversified growth funds or use a partial growth strategy to protect them. There are several branches you can use:
- Growth At A Reasonable Price – GARP investing adds a value investing discipline to growth by waiting for the right price. Basically, GARP lowers the margin of safety requirement. Both Philip Fisher and Peter Lynch specifically mention the importance of not overpaying for growth stocks in their books (both books are in the recommended reading list).
- Dividend Growth Investing – follows the GARP strategy with a focus on growing companies that pay a dividend, since they typically increase the dividend over time. The dividends act as an income source and price stabilizer and when reinvested, compounds the growth rate.
While growth is the main goal there are a few basic principles to keep in mind when you look for growth stocks:
- Future Growth Potential – this potential must be high since growth investors are willing to pay a higher stock price for future growth. There’s a big emphasis on growth forecasts and exceeding those forecasts. Remember, forecasts are just estimates or best guesses.
- Above Average Growth – the company is growing revenues and earnings faster than the average company. Again, faster growth is the key and over a longer period.
- Capital Gains – the nature of growth investing emphasizes long-term capital appreciation. Growing companies typically retain and reinvest earnings to grow the company and not payout a dividend. Those that do pay a dividend, its only a small portion of earnings (small payout ratio).
- Capable Management – a company stops growing for one of two reasons and mismanagement is the big one (product/market saturation is the other).
Owning stock of a growing company will help you beat the market over a long period. In its purest form, that’s what a growth strategy does. But it also has it’s faults. Which is why some of the best growth investors have taken aspects from other strategies and morphed it with growth to add protection and lower risk. This leaves you with several ways to use this investment strategy.