Growth Stocks, What They Are, What They Are Not

Posted on Friday, July 27th, 2018 MarketBeat Staff

You can often get a clue about the type of investor you are, and what your risk tolerance may be, by examining what type of consumer you are. Ask yourself this question. For purchases that require you to spend an amount of money that is significant to you, are you more likely to buy a great product at a fair price, or a fair product at a great price? If you answered the former, then you are likely an ideal candidate for investing in growth stocks. In this article, we'll define exactly what growth stocks are and are not, what is the history of growth investing, and how you can invest in growth stocks.

What are growth stocks?

Growth stocks are shares in companies that have a strong history of rapid earnings growth. This growth, in turn, allows their stock prices to rise, usually at a pace that will outperform the broader stock market. For investors, growth stocks are the stocks that dreams are made of.

One of the fundamental attributes of a growth stock is that the company will reinvest their earnings without providing a dividend. This is fundamental to a growth stock because as an investor you’re buying these stocks with the intention of the stock generating capital gains for you, not providing a steady supply of income. 

Growth stocks do not fall neatly into a specific sector and are not traded on a specific exchange (i.e. NYSE, Nasdaq). Instead what investors should look for are the qualities that make up a growth stock. These are generally companies in industries that are rapidly expanding or where there are new technologies being introduced and developed. Frequently, growth stock companies will hold patents for the products that they bring to market.

To understand why it’s important to look for growth stocks in these markets is to understand fundamental market theory. When a new product is introduced, particularly in the technology field, it typically is priced at a premium to bring in the early adopters. If the product has patented technology, all the better. Competitors may be able to imitate the product, but they won’t be able to duplicate it. This is the sweet spot where sales go up, and along with it the value of the company, and their share price.

You’re also not looking for the cheapest price. With growth stocks, you’re looking for the highest quality that you can afford, not the best “value” for your money.

What growth stocks are not

With this in mind, it is sometimes easier to define growth stocks by what they are not, then for what they are.

Sometimes you’ll hear that “blue-chip stocks” are growth stocks. Blue-chip stocks are, in general, the stocks that make up the Dow Jones index. And, to be fair, some of these stocks are still capable of outperforming the market. Perhaps a better way to view them, however, is that, in many cases, blue chips are growth stocks that are all grown up. Think Apple and Amazon. These stocks used to be considered the darlings of the growth investing community, and in fairness still, demonstrate innovation that can lead to consistent growth. But they’ve obviously become larger and with that size comes less elasticity in their stock performance. And, in the case of Apple, they began to reissue a dividend several years ago, and there is speculation that Amazon may be ready to do the same. For these reasons, growth investing “purists” may not characterize these stocks as true growth stocks. Growth stocks are not penny stocks.

For true growth investing disciples, small-cap companies are where to look. These companies have sales in the $50 million to perhaps $250 million range. This allows for more rapid company growth, and stock prices that have more room to grow.

You may also hear the term “cyclical stocks” thrown in with growth stocks. Again, there’s a possibility that some of these stocks may have growth potential. However, by definition, cyclical stocks rise and fall with the economy. A true growth stock is more evergreen. It will have its ups and downs, to be sure, but the trend will be towards growth regardless of the economy’s performance.

Reviewing the history of growth investing

The 1930s. The Great Depression. A stock market that has lost nearly 90% of its value. Would you imagine that the origins of growth investing were born in this investing environment? But it was. Thomas Rowe Price Jr., the founder of the investment firm T. Rowe Price, is recognized as the father of growth investing.

Price was a contrarian. So while others were racing to get out of the market, Price saw an opportunity to jump in. In Price’s point of view, the Great Depression was actually part of a normal economic cycle and there were still good opportunities for investors.

So what did he look for? Companies who lacked competition, that were protected from government regulation which was expanding in the New Deal. Price was also looking for companies that were providing a return of at least 10% on their invested capital as well as high-profit margins and strong earnings-per-share growth.

His first growth stock fund, introduced in 1950, generated a return of nearly 400% over ten years. It was also during the 1950s that investment legend Phil Fisher authored the book “Common Stocks and Uncommon Profits” which is considered, even today, to be a reference for finding growth companies. Where Fisher departed from Price was in his focus on innovation and technology stocks. These companies were putting their equity into research and development. Both Fisher and Price advocated growth investing for the long term.

Historically, growth investing has fallen out of favor when growth stocks are perceived to be overvalued. This was the case in the 70s and 80s, and again after the tech bubble burst in the early 2000s. However, even during those periods, there have been companies that have shown the ability to weather the downturns and have rewarded investors by rising to new heights.

How to invest in growth stocks

Think of these as assets that will appreciate over time. If you’ve done your homework and you have rational, not emotional, reasons to believe in the company’s prospect, then you will be equipped to ride out the inevitable highs and lows that come with growth investing.

One of the easiest ways to purchase growth stocks is through a mutual fund. Many mutual funds are sorted by investment objective so it’s not hard to find ones that specialize in growth funds. These funds invest in a basket of established companies who meet the criteria of growth investing (i.e. rapid earnings growth with a corresponding increase in stock price).

A word of caution, some mutual funds are labeled “Growth and Income” or “Aggressive Growth”. Growth and Income funds include companies that pay dividends. So, while they may include some growth-oriented companies, the goal is long-term growth without the volatility in stock prices. This may be more conservative than what you are looking for.

On the other end of the spectrum, aggressive growth funds may be venturing into the area of speculation. These funds typically invest in companies who are either struggling or are relatively new companies that have good prospects, but no proven track record. Again, just because they have growth in their name does not make mean they should be in your portfolio.

The other way to add growth stocks is to choose them yourself. Many investors find this to be very enjoyable. And the good news is that there is no absolute right way or wrong way to make selections. Choosing the right growth stocks (or any stock for that matter) requires a bit of trial and error as you refine the way you interpret the information you find.

When looking at growth stocks, any of the following data points should be as a guideline but always compared to a particular company and their situation. And what may be true for one company or industry may not be true of another. With that said, here are some things to look for:

  • A history of strong, historical earnings growth. This seems simple. If a company has a solid record of growth in recent years, it is more likely to continue that trend. A company you are considering investing in should have a proven history of growth over 5 to 10 years. However, when it comes to growth, one size does not fit all. You should expect the percentage of year-over-year growth to be higher for smaller companies (i.e. under $400 million) than you would for larger companies. You’re looking for consistency, not a specific number. It may also help to compare a company you’re targeting with another in its industry.
  • The potential for strong forward earnings growth. If you’re in tune with the financial news cycle, you’ll hear the words “earnings season”. These are the point in a calendar quarter when companies make their earnings announcements. These announcements will either meet, exceed, or fall short of the estimates made by equity analysts. If a company meets or exceeds analysts’ expectations that can be viewed as a positive sign of future growth.
  • They should have strong profit margins. This means the revenue earned after deducting all expenses from sales (except taxes) and dividing by sales. If earnings are not in line with sales, it could mean that there are underlying factors affecting cost control and revenue. You can usually find a company’s five-year average of pretax profit margins. Viable candidates should demonstrate a consistent history of exceeding this five-year average.
  • They should be getting a strong return on equity. Return on equity (ROE) measures how much profit a company is generating with the investments made by shareholders. Again, this is a number that should be viewed over time. If the number is stable or increasing, it means that the company is operating efficiently and doing a good job of generating a positive return on the money they receive from their shareholders.
  • Their stock should show strong performance. Growth stocks by definition are companies in rapidly expanding industries. There is an expectation of growth. And if the stock of a particular has not, or does not appear to have the potential to double in five years (a growth rate of 15%) then you should proceed with caution.

The bottom line on growth stocks

The allure of growth stocks is to buy low and sell high. You're not looking for dividends to provide a steady stream of income. You're looking for above-average earnings that will entice other buyers into the market, lifting the stock price. This, in turn, will allow you to make a profit.

Investing in growth stocks, however, is still investing. And investing for growth frequently requires patience. Trying to time the market, particularly when it comes to growth stocks, is usually a sucker’s bet. These stocks are typically more volatile than the broader market. That doesn’t make them speculative investments like penny stocks; it just means that stocks never trend in one direction all the time. You’ll have ups and downs along the way. You may have to wait several years before getting the return you want.

When you’re considering investing in growth stocks, it’s still wise to use tried-and-true principles like dollar-cost averaging and buy-and-hold to give yourself a hedge against the whims of the market. 

Growth investing has a place in every investor’s portfolio. Even the most conservative investor can benefit from having a percentage of their portfolio set aside for growth, which can help ensure enough money to last throughout your retirement. And younger investors may want to consider having a larger percentage of their portfolio in growth stocks to help generate wealth.

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