Your investment strategy plays a major role in your profitability, or lack thereof. One of the most popular strategies investors employ is known as the growth investing strategy. The strategy is centered around finding and investing in stocks that have experienced compelling growth in recent history, and tapping into the ongoing growth potential.
But what exactly is a good growth stock?
Characteristics of the Best Growth Stocks
If you’re looking for stocks with incredible growth potential, ultimately hoping to cash in on the upward volatility to generate profits, you’re looking for stocks that display the following characteristics.
1. Stock Price Growth
For a stock to qualify as a growth stock, it has to be experiencing growth in its share price. Without price appreciation, the stock simply doesn’t fall into this category.
So, how do you determine if a stock is on an upward trend?
The easiest way is to take a look at the stock chart.
- Look at Three-Month and One-Year Stock Charts. It will be clear whether a stock is trending upward when you look at the chart. If the share price has seen relatively consistent upward movement, there’s a strong chance you’re looking at a growth stock. It’s important to look at the chart over the past three months and one year. The three-month chart will tell you whether the trend is currently upward and the one-year chart will tell you whether the growth in the stock has been sustained over a significant period of time.
- Forgive Dips. Even in bull markets, stocks that are climbing will dip from time to time as investors take profits or digest pieces of news. What you’re looking for is an overall performance in the upward direction, ignoring short-term dips in the data.
- Compare the Growth to the S&P 500. The S&P 500 index is the primary benchmark of the United States market. By comparing the growth of the stock you’re interested in over the past three months and one year to growth in the S&P 500, you’ll be able to determine whether the company’s stock price has underperformed, performed in line, or outperformed the wider U.S. market. After all, the goal here is to find high-growth stocks that outperform market returns.
After looking at the charts, if you find that the stock has outperformed Wall Street averages over the past three months and one year, chances are you’ve landed on a solid opportunity to beat the market with your investing dollars.
2. Earnings Growth
Sustained gains in the value of a stock will only be possible if the company you’re investing in sustains growth in profitability. Who wants to continue piling money into a company that’s losing it all?
Determining earnings growth is a relatively simple process, thanks to a tool provided by Nasdaq. To access the tool, visit the Nasdaq website and look up the stock ticker you want to research. On the left of any stock’s profile is a link titled Earnings you can click for more details.
The resulting page will have a graph that shows the earnings per share on a quarterly basis over the past year. Look for consistent quarter-over-quarter growth in earnings. Also, pay attention to the earnings surprises. Stocks that have all positive earnings surprises consistently beat analyst expectations — a great sign for a growth stock.
3. Revenue Growth
It’s also important that the stock you invest in has a track record of impressive revenue growth. There are ways to reduce costs to inflating earnings while revenue is either plateauing or falling. These methods will only last so long, and earnings will begin to falter at some point if there isn’t real revenue growth underneath.
So, it’s important to make sure that the stocks you’re interested in are experiencing consistent and compelling growth in revenue.
To determine whether revenue is growing, simply look into the company’s last four quarterly earnings reports. Take note of the revenue reported in each quarter, keeping in mind normal peaks and valleys seen in the sector.
For example, tech companies tend to do best around the holidays, leading to strong fourth quarter revenue. As a result, companies in this space may see a plateau in revenue, or even slight declines, from the fourth quarter to the first quarter, which would be acceptable as long as revenues sequentially rise throughout the rest of the year.
Pro tip: Stock screeners like Trade Ideas and Stock Rover can help you find companies that meet or exceed most of your requirements for things like revenue growth, earnings per share, and other key metrics.
4. Market Growth
You may be noticing a trend here. The key to growth investing is finding a stock with sustained growth across all metrics, but the stock and the company it represents aren’t the only factors you should be paying attention to.
Growth in the addressable market the company you’re interested in targets is also crucially important to its ability to realize sustained gains in revenue, earnings, and ultimately share price.
If a company is beginning to capture the majority of the market it addresses, it may be going through a growth spurt, but that upward movement won’t be sustainable if the market size remains flat. At some point, the company will have saturated the market and will eventually plateau itself.
So, it’s important to look into market data to determine whether the market in which the company operates is growing at a rate capable of supporting continued upward movement in the stock you’re investing in.
To do so, simply go to your favorite search engine and type “(industry) market size” into the search bar and read through the results. In most cases, several statistics companies have performed detailed analyses of the market, determining the current market size and the size the market is expected to achieve over the next several years.
If the company you’re considering is working within a market that’s plateauing, look into how much of the market the company has already penetrated to determine how much more room is left for upward movement.
5. Free Cash Flow Growth
Money flows in and out of businesses like water. Free cash flow represents the net amount of money that flows into a business once all outflows are taken into consideration. This differs from profitability because free cash flow does not measure non-cash expenses such as depreciation.
It’s important to make sure there’s consistent growth in free cash. This can be seen by looking into the company’s balance sheets over the past four consecutive quarters.
6. A Fair Valuation
Growth stocks are notorious for reaching significant overvaluations after big runs higher, resulting in dramatic declines when investors take profits and move on to the next opportunity. While an average valuation is to be expected, risk levels increase when prices fly too high.
One of the best ways to determine if a stock is undervalued, overvalued, or valued fairly is to look at the price-to-earnings ratio, or P/E ratio. A metric commonly used by investors looking for value stocks, the P/E ratio compares the price of the stock to the earnings per share generated by the company over the course of a year.
Every industry will have its own average ratio. By comparing the ratio of the stock you’re interested in to that of the market in which it operates, you’ll be able to determine if the current value of the stock you’re interested in is fair.
7. A Strong Balance Sheet
This has little to do with growth and more to do with general investing due diligence. Any time you buy a stock, you want to make sure that the underlying company has a strong balance sheet.
The balance sheet will clearly outline the value of the assets the company owns as well as the debt it owes, giving you an idea of whether the company is sitting on a strong financial foundation.
8. Clear Competitive Advantages
In order for a company to maintain an upward trajectory, it has to have clear competitive advantages. For example, compare BlackBerry and Apple when it comes to their activities in the smartphone space.
BlackBerry was a clear pioneer, creating some of the first devices classified as smartphones. Over time, competitors came in, taking market share from the company until “BlackBerry” became “Black-What?”
On the other hand, Apple jumped in with a clear competitive advantage. The company consistently innovated new ways to use smartphones, put together an ecosystem including an app store, music service, and more. Apple continues to improve the experience for users of its smartphones to this day, many of whom refuse to switch to other devices despite there being many choices in the smartphone market. As a result, Apple is touted as one of the best growth stocks on the market today.
9. A Solid Management Team
Like a chain, a company’s team is only as strong as its weakest line, and those weak links are sometimes found in management.
When investing in a company, you’re trusting that company with your money, meaning you’re trusting the company’s management team to make moves that will lead to growth.
Why would you trust a team of people you know nothing about?
Before investing in any stock, you should dig into the management team at the helm of the company. How long have members of the team been with the company, and what have they done since taking on their positions? Where did these team members work before, and did their work with previous companies lead to positive outcomes?
These are questions you should know the answers to before you dive in.
10. Forward-Looking Growth Prospects
Finally, before buying a stock you expect to grow substantially ahead, it’s important to take a look at the company’s growth prospects. What is its story for how it will grow and expand into the future?
For example, Gevo, a company focused on the production of clean fuels, is a hot topic among growth investors at the moment. Investors are excited because the company has signed several agreements that will open the door to expanding revenues in the years ahead. Moreover, the company is working to expand its infrastructure to meet increasing demand. Based on the activities taking place at the company, investors are excited about the expectation of meaningful growth in the value of the stock moving forward.
Any growth stock you invest in should have compelling forward-looking growth prospects, such as a plan to enter a new market, a strategy for making their products or services more widely available, or new products in the pipeline.
Consider Investing in Growth ETFs
Finding and taking advantage of growth opportunities in the market can be a cumbersome process, taking quite a bit of time. If you don’t have the time to dedicate to the process, or the expertise it takes to research each and every investment opportunity before risking your money, you may want to consider investing in exchange-traded funds (ETFs) with a focus on growth strategies instead of picking individual stocks.
Although investing in growth-focused funds will reduce the amount of research required, it’s still important to look into each fund’s historic performance, expense ratio, and dividend yield before diving in.
Investing in growth stocks has the potential to be a lucrative business. The potential to produce market-beating returns has made the growth investing strategy one of the most popular among retail and institutional investors alike.
As with any other investing strategy however, research forms the foundation of successful investment decisions. Taking the time to dive in deep and make sure the stocks you invest in display the above characteristics will greatly increase your potential profitability.