In this beginners guide to growth investing, I’ll be guiding you through this popular investing strategy. I’ll explain the theory of growth investing, how to spot a hot growth stock, and how a growth investing strategy can complement your portfolio.
Growth Investing – A Beginners Guide
What is growth investing?
Growth investing in an investing style. It’s an investing strategy which investors use to decide which companies to invest in.
Buying shares is a difficult process because of the problem of choice. There are over 100,000 companies listed on the stock exchanges of the world. How do you decide which companies will deliver you a better return than the market average?
An investing strategy like growth investing offers a simple way to narrow down this long list of ticker symbols. The focused philosophy of growth investing favours the shares of companies which exhibit high growth characteristics.
Invest in the small percentage of companies which meet the ‘growth’ definition, and you will enjoy a return which exceeds the market average. Or at least, this is what followers of the growth investing strategy subscribe to.
An introduction to growth investing
At first, growth investing sounds like the thing to do.
‘Of course I should invest in the companies which are generating the highest growth!’
This reaction is entirely sensible and represents the first stepping stone of the three steps to understanding the growth strategy.
The next thought process is to apply the theory of efficient markets and the skepticism that this brings:
‘But if everyone values the bright prospects of these companies – they’ll be overpriced – all of my future gains have already been enjoyed by the earliest investors’
This is again, an entirely logical conclusion. The efficient markets hypothesis reminds us that, as a public market with rationale and informed participants, the prices of shares should reflect their prospects.
Struggling companies should be priced at a discount as they’re out of favour, and frothy valuations will accompany hot stocks which have excellent PR and plenty of good news. Each company should be priced at a level which offers any investor an equal chance at earning a fair risk-adjusted return.
The final step is to look at the historical performance of the growth investing strategy:
‘Actually, in spite of their premium prices, growth companies have continued to outperform other investing styles in recent decades’.
As the Financial Times has reported, growth investing has built a considerable lead over value investing.
How to apply the growth investing approach
Growth investing is not a holistic approach to investing in general – it’s a stock-picking method for stocks and shares. It’s about knowing what to invest in in a sea of choice.
This means that before you throw all of your money into tech stocks, you should be laying the groundwork by building a basic investment portfolio around them.
Growth stocks are generally regarded as slightly higher risk than the average company, because they tend to be more sensitive to bad news and their prices have further to fall.
How to pick growth stocks & shares
To follow the growth investing strategy, you will want to look for companies with:
- A high rate of growth in revenue
- A high rate of growth in earnings or net profit
These trends should be evident over a number of years to be considered a growth factor. Any tiny business can claim growth figures in the 100s ot 1,000s of percent when they’re starting from nothing.
Take a look at these examples of growth stocks. These are not buy recommendations.
Growth stock case study: Netflix Inc
Netflix’s annual reported revenue:
Netflix is an excellent example of a growth stock, because it has delivered an unbroken record of revenue increases since it listed as an Initial Public Offering (IPO) in 2002.
Growth stock case study: Rightmove PLC
Rightmoves’ annual reported revenue:
Rightmove, a popular British online property search portal, has demonstrated how growth looks at a small scale in the UK. Rightmove has managed to successfully generate more and more revenue from a property market that has largely flatlined over the same period.
This ability to grow in spite of any market conditions, such as Brexit and recession fears, is one reason why it has remained popular with investors. As a result, Rightmove plc was one of the top 10 performing UK shares over the decade to the end of 2019.
Other characteristics of growth stocks
Growth stocks tend to have the following features. Although they’re not necessarily desirable qualities, they come alongside investing in growth companies:
A high price to earnings multiple
Growth stocks are often highly valued, resulting in a high price to earnings multiple.
This is because investors are valuing the business on its potential to scale further in future years and deliver earnings on a much larger scale. The valuation of growth stocks, therefore, tends to advance ahead of this growth being delivered.
You will often see growth stocks in the headlines for achieving a market value higher than many established competitors which appear to:
- Sell more products
- Make more money
- Have a better known brand
This is a curious side-effect of a company trading at a much higher multiple than its competitors. It is often accompanied by exclamations that the company is certainly overvalued. However, what is actually happening is that the stock market expects that the future business of the challenger company to be far larger or more profitable than its rivals.
Tesla is a good example.
Low dividend yield
Growth companies tend to have low dividend yields. In fact, many don’t pay any dividends at all.
Does that shock you or can you figure out why?
The reason is that when a company pays a dividend, it starves itself of cash it could have used to fund a new sales team in a new country, or spent on research & development.
Many growth companies also have low earnings – so they don’t have the profits to fund a dividend in the first place.
A growth investor is not looking to extract the earliest income from a stock. They are looking to buy and hold the shares for a long period of time, to allow the company to do what it does best – grow!
Growth investors may pay a premium price for their shares, but they hope to be able to sell them for a staggeringly high price a few years down the line.
If you’re a huge fan of receiving dividend income each quarter, you might want to consider the dividend growth investing strategy instead.
Is growth investing a successful strategy?
As I alluded to above, growth investing has actually been a superior strategy to value investing.
“Value funds have returned 624 per cent since 1995, while growth funds have returned 1,072 per cent over the same period,” – Financial Times.
This is an eye-watering figure which tops virtually all other asset classes. Any investor would have been happy with their results if they had adopted the growth investing strategy in the wake of the dotcom boom.
However, as always, this isn’t a guarantee of future returns. An investing strategy shouldn’t be able to permanently outperform another investing style… in theory. On paper, more investors would continue to crowd into the same shares and ensure that everyone pays a terribly high price. This would erode returns in the future.
Some speculate that after underperforming for so long, the next decade will be the decade of the value company. What do you think? Leave a comment below.
Are there downsides to growth investing?
Like all investing styles, growth investing has its pitfalls.
The first is its lack of dividend income. Investors who seek income, such as people in retirement, will not find it as convenient to follow the growth investing method.
This isn’t a total road block. It’s still very possible for an income investor to follow a growth investing style. However, they will need to sell blocks of shares or units in funds periodically to raise the cash they need to supplement their state pension.
An appetite for ‘hot stocks’ and strong track records can attract growth investors to the bubbliest areas of the stock market.
The technology sector has been the home of many high growth companies – particularly software or web platforms, which are able to scale their offering by an order of magnitude each year by simply paying for more web servers.
With the right concept, tech companies can benefit from strong networking effects which can create a monopolistic effect. With this market dominance comes high gross margins. As a result, tech companies such as Google, Facebook, and Tencent have been grown to become some of the most profitable companies in the world.
The tech sector does, however, come under constant fire from market observers as being detached from reality. A common criticism is that the valuation of these companies, despite their maturity, continues to remain at a very high multiple, purely on the basis that these are ‘tech companies’.
We can often fall into the trap of comparing all tech unicorns and assuming that they’re all cash printing operations.
However, many companies which are valued at over $1bn are still not profitable, and have yet to ‘actually’ demonstrate that they can generate a return to shareholders.
Uber is a classic example. Despite being a household name, and creating an app which is used by millions the world over, Uber is yet to actually turn a profit.
A more recent and notorious example of a profit deficient growth engine is WeWork, which withdrew from IPO in late 2019 after the markets soured on its high-risk business model. WeWork had previously aimed to sell shares to public investors at a valuation of $60bn, despite losing over $200,000 per hour.
This certainly presents a risk to growth investors who focus heavily on tech companies. If these are the kinds of investments you chase, then you’ll be in for a bumpy ride.
Zany, revolutionary or new business models may only be valuable so long as investors have faith that they may one day turn a profit. When the star appeal wanes, or a technology fails to deliver the transformative potential its charismatic leader once proclaimed, these tech valuations can come crashing down.
Sometimes, that faith is rewarded – ask any early investor in Tesla.
But for every Tesla, there are multiple WeWork examples. It’s difficult to tell which is which without the benefit of hindsight.
Examples of growth investing funds (UK)
Rather than picking growth companies and managing a portfolio yourself, you could choose to invest in cheap UK equity exchange-traded funds or pick other funds which adopt a growth investing strategy.
Each fund will have a slightly different methodology and strategy to pick their stocks, therefore look online for their prospectus (or even better – an interview with the fund manager themselves) to understand how they design their portfolios.
In the UK, growth investing funds tend to contain ‘growth factor’ or just ‘growth’ in their fund name. Examples include:
- AXA WF Framlington UK
- Unicorn Outstanding British Companies
- MI Chelverton UK Equity Growth
- Premier UK Growth
- Slater Growth
- Fidelity Special Situations
I hope you’ve found this beginners guide to growth investing useful.