What is growth stock investing and how do you do it?
There are several ways to go about investing in the stock market. One of the most popular investment styles is growth investing.
Growth investors seek to tap into companies that have a compelling history of growth and are likely to continue on an upward trajectory. Growth investors bet that the trend in a growth stock will continue, allowing them to achieve alpha — producing returns greater than that of the overall market.
Is the growth investing strategy right for you? Read on to learn what you need to know.
What Is the Growth Stock Investing Strategy?
As mentioned above, growth investors look for opportunities to invest in companies that are known for producing growth that outpaces their peers. These companies produce strong growth in revenue, earnings, cash flow, and stock price, resulting in above average returns for the investor.
A great example of a growth company is Amazon.com. The company consistently beats earnings and revenue expectations, and its stock is one of the fastest growers on the Nasdaq today.
However, many companies in this category can’t maintain the compelling growth forever, and growth stocks are known for high levels of volatility. That volatility means exciting runs higher when things go well but also painfully sharp declines when the music stops. As a result, growth investors tend to make relatively short-term moves and have a healthy risk tolerance.
How Growth Stock Investing Works
Growth investing generally starts with the investor using a stock screener to find suitable opportunities. Growth stock investors set the screener to show stocks that have outperformed others in their sector in terms of share price appreciation.
Once a few companies are dialed in, the investor performs fundamental analysis, looking at various metrics to determine whether the company’s growth rate truly outpaces its competitors and the growth potential of the stock in the future.
Some of the most important metrics growth investors analyze include:
- Earnings Growth. A company’s earnings growth tells investors how hard the company is working to increase profitability. Investors like to see earnings that are consistently growing on a quarter-over-quarter and a year-over-year basis.
- Free Cash Flow Growth. Free cash flow is the amount of money flowing into the company in excess of the amount flowing out. Increases in free cash flow suggest the company’s financial standing is improving and its business model is successful.
- Revenue Growth. It’s possible to produce earnings growth for a short period of time even when revenue growth has stalled. So investors pay attention to revenue to ensure sales are constantly increasing.
- Clear Competitive Advantages. For a company to continue outpacing its competitors, it has to have clear competitive advantages. Growth investors look for the same kinds of advantages investor Warren Buffett famously describes as an “economic moat” that protects the company from competition, such as brand loyalty, patents, or other intellectual property.
- A Strong Balance Sheet. A company’s balance sheet gives investors a look at how the company is funding its operations, whether it’s through debt, operations, or investor equity. A great stock for a growth investor should be making enough money from its operations to fuel continued growth in the future. If the majority of a company’s operations are funded through debt, look elsewhere.
- A Strong Management Team. In order for a growth company to stay on top, it has to be led by a strong management team. Investors often look into the management of companies before investing, taking the time to dig into the history of each member of management to determine how successful they’ve been in the past.
- Price Appreciation. None of the above matters if investors aren’t paying attention. Ultimately, supply and demand move the market. One of the strongest signs of a solid growth company is consistent stock price appreciation above and beyond the average for its industry.
Types of Growth Investments
As with any other investment style, there are multiple ways to go about growth investing. Two of the most common options include:
Individual Growth Stocks
Many growth inventors choose to search for individual stocks that display strong growth characteristics. These investors tend to focus on stocks in high-growth sectors including:
- Technology. Technology companies are at the forefront of innovation in many other sectors. When they come up with new innovative technologies, growth is likely to follow. Tech stocks tend to do incredibly well when the overall market is performing well and fall hard in times of overall market declines.
- Health Care. Health care stocks are a more stable option for the growth investor. New medicines, devices, and methods for treating countless conditions are released regularly. New discoveries and medical advances give health care companies the potential to dive into multibillion-dollar markets, setting the stage for growth.
Although technology and health care stocks are among the top of the list for the growth investor, many who follow this style of investing are happy to take advantage of any opportunity on Wall Street that fits in with their investment objectives.
Another option that’s appealing to many investors is investing in growth funds. These are exchange-traded funds (ETFs) or mutual funds that focus the brunt of their investment portfolio on the growth category of stocks.
Rather than choosing the next mega success years in advance, many growth investors prefer to invest in the category and let the pros on Wall Street figure out which exact stocks to invest in.
Fund managers pool investing dollars from a wide range of investors, using those dollars to make investments according to their prospectus. Some of these funds act as index funds that track an underlying benchmark of high-growth companies or sectors. Others actively manage assets, using a team of professional traders to take advantage of growth opportunities on the market.
Growth Investing vs. Value Investing
Value investing is another popular style of investing that suggests buying stocks at low valuations sets you up for outsize growth during a recovery. Whereas growth investing requires the analysis of a company’s current growth to determine future growth, value investors analyze the stock market valuation of a company to determine whether buying shares will provide them a discount.
Essentially, value investors are looking to buy stocks that are temporarily “on sale” and hold onto them until they return to a fair market price.
Value stocks are assessed using a wide range of ratios like the price-to-book value ratio (P/B ratio) and the price-to-earnings ratio (P/E ratio). Comparing these ratios to those of other companies in the same sector, investors look for stocks that have a low price relative to earnings, book value, sales, and other metrics.
Growth Investing vs. Income Investing
Income investing is centered around generating dividends from investments. These investors aren’t interested in high-risk opportunities to outpace the market. Instead, they look for long-term investments that provide meaningful income.
While these investors like to see price appreciation coupled with revenue and earnings growth, that growth tends to happen at a slower rate. Most income investors are trying to avoid risk and are willing to accept slower growth as a trade-off.
Pros and Cons of Growth Stock Investing
There are pros and cons to consider regardless of the style of investing you choose to use. The most significant pros and cons of growth investing include:
Pros of Growth Stock Investing
Some of the biggest perks to investing in growth stocks include:
- Potential to Beat the Market. Successful investors who follow a growth strategy have the potential to generate returns well above the average gains across the market.
- Excitement. Growth stocks happen to be in exciting categories. Learning about the latest and greatest in technology, biotechnology, and medicine makes investment research in these areas more exciting.
- Invest In What You Know. Chances are you already use products offered by some of the highest quality companies in the sector. Household tech names like Apple, Amazon, and Google have a long history of jaw-dropping growth.
- Based on Fundamentals. An investor focused on growth relies on fundamental analysis, which is mostly rooted in common sense. Although familiarity with arcane technical analysis is a plus, you don’t need it to be successful, making growth investing a possibility for those who aren’t keen on trying to read the tea leaves in a stock chart.
Cons of Growth Stock Investing
Sure, you might be excited about jumping into growth opportunities in the market, but there are a few drawbacks that should be considered before getting started:
- Risk. Growth stocks are known for high volatility, and that volatility can go in either direction. For example, after a tremendous run in 2021, many growth stocks fell like a brick in early 2022 as the market corrected. Investors must be cognizant of the risks before getting involved.
- Must Strictly Adhere to a Strategy. With the risks involved in growth investments, investors must strictly adhere to their strategies. Allowing emotion to get involved in the process can lead to significant downside risk.
- The Potential to Buy at the Top. Above-average growth is rarely sustained for a period of several years. Sure, there are the Amazons of the world that have beaten the odds, but the vast majority of stocks will revert to fair market pricing at a reasonable rate of growth, which could mean losses for investors who buy at the top of the run.
How to Get Started With Growth Investing: Beginner’s Guide
Getting started as a growth investor is a relatively simple process. Follow the steps below and you’ll be well on your way:
Step #1: Choose Your Style
There’s quite a bit of research and fundamental analysis involved when investing in individual growth stock opportunities. If you’re confident in your stock research abilities, have the time to adequately evaluate opportunities, and would rather have full control over your portfolio, your best bet is to choose individual stocks.
If you decide to invest in individual stocks, you’ll want to define a clear plan, outlining the amount of growth you’re looking for and a clear exit strategy.
On the other hand, if you’re a newcomer to the investing stage and aren’t a confident researcher, don’t have the time for research, or would rather a professional make the hard decisions for you, investing in growth funds will be the better option for you.
Hint: If you’re a newcomer to the market and want to invest in individual stocks, take the time to test your strategy using a trading simulator before investing with your hard-earned cash to avoid losses due to common beginner mistakes.
Step #2: Open a Brokerage Account
Before you can buy your first stock, you’ll need a brokerage account. There are several online brokers that offer commission-free trades to choose from. Compare your options and choose the broker you feel will be the best fit for you and your style of investing.
Step #3: Assess Growth Opportunities
The methods for assessing opportunities will be different depending on whether you’re investing in individual stocks or investment-grade funds. Here’s how it works out:
Investing In Funds
Those investing in funds will want to assess several options, keeping the following factors in mind:
- Historic Performance. Although historic performance isn’t always indicative of future results, it’s a great measure of how successful the manager at the helm of the fund has been over time.
- Expense Ratio. ETFs and mutual funds come with expenses that are outlined as expense ratios, or the percentage of your investment that will be used to cover annual expenses. Expense ratios will vary widely from one fund to the next, and a high ratio will cut deep into your profitability. Be cognizant of the fees you agree to pay when investing in an investment-grade fund.
- Assets. Investment funds let shareholders know exactly what assets they hold and how much. Use this info to select funds that invest in what you’re interested in. If you’re specifically interested in technology assets, you’ll want to look into the fund’s holdings to ensure the majority of its portfolio is held in the tech sector.
When choosing individual investments for your growth portfolio, you’ll want to consider the characteristics of growth stocks outlined above. This includes growth in revenue, earnings, free cash flow, and share prices coupled with a strong management team, balance sheet, and clear competitive advantages.
It’s also wise to look at the valuation of companies before investing as well. Although growth stocks generally have higher valuations than value stocks, it’s important that you don’t significantly overpay compared to others in the sector. Overvaluations suggest the run may be over soon, and you may get stuck buying in at the top.
Step #4: Keep Diversification In Mind
If you’re investing in ETFs and mutual funds, the diversification is taken care of for you simply through your style of investing. However, if you’re investing in individual stocks, it’s important to diversify your holdings.
One of the best rules of thumb to follow when doing so is known as the 5% rule. The rule suggests you should never invest more than 5% of your equity holdings into a single stock or more than 5% in a group of high-risk stocks.
Although growth investing comes with added risk, the best of these stocks are well-established companies that don’t fall into the high-risk category. Nonetheless, it’s important to keep your maximum investment in any single stock to 5% to ensure you don’t take too big of a hit if you miss the mark on a trade or two.
Step #5: Stay On Top of Your Portfolio
Things happen fast with growth stocks, both good and bad. If you follow this strategy, it’s important to stay on top of your investments. If things go wrong, you’ll want to be aware so you can act quickly and avoid losses.
Also, consider setting up a trailing stop-loss order on all trades. Volatility is to be expected, but you don’t want to lose too much money in the beginning of a trade or too much of your profits during a reversal. Setting a trailing stop-loss at 5% below the stock’s highs will help you avoid significant downturns and lock in profits on your trades.
The growth investing strategy is an exciting and potentially lucrative one, but it’s not for everyone. Because of the risks involved and the intense research required, the strategy is best for younger, risk-tolerant investors who are looking for an aggressive approach to achieving alpha.
Retirees and other low-risk investors should consider other investing styles, like income or value investing.