Yahoo Finance An Introduction to Growth Investing
Growth investing sets aside strict fundamentals to identify companies potentially poised for above-average growth rates and long-term potential. Picking companies that will go on to maintain high levels of growth over long periods of time isn't easy, and most successful growth investors who have been at it for a while will tell you that they have had more than a few misses along the way. However, buying a stock like Amazon.com or Netflix in its early stages, and holding on as the business expands and enjoys an incredible rise, tends to reward investors with life-changing returns.
In order to increase your odds of finding the next big success stories with this investing style, it's helpful to have some growth investing criteria in mind and a solid grasp on some core concepts so you know what to look for -- and how to look for it.
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How earnings affect stock performance
When you buy stock in a company, you are buying an ownership stake, and this means that your shares generate a proportionate share of its profits. Therefore, a business' earnings and potential for future earnings growth are primary factors in valuing a stock. An investment in a stock that's been posting big growth is typically a bet that it will continue to see substantial earnings gains going forward. If it succeeds on that front, or surpasses expectations, investors will likely be willing to pay more for its stock. If it falls short, it's reasonable to expect that its share price will fall -- as this ownership stake in the company will be perceived as being on track to produce less profits.
If you buy a company that is trading at 10 times the amount of earnings that it posted in the previous fiscal year, and it maintains that constant rate of profitability, it will take 10 years for the company's profits per share to cover the price of your initial investment. The faster earnings grow, the faster the business' profits will match and surpass the price an investor has paid for a stock. This dynamic explains why high-growth companies are "more expensive" relative to their sales and earnings in a given year than those that are posting slower rates of expansion.
Investors are willing to pay a higher earnings or sales multiple with the expectation of strong growth in the future will reveal new value in the company. Over the long term, earnings growth is the best predictor for a stock's performance. It's also important to proceed with an understanding of the risks inherent to valuing a company based on its growth potential. If a company posts rapid sales growth this year only to deliver disappointing revenue gains in the next, its share price stands to see a substantial decline. So, as a general rule, growth investing will tend to be more high-risk, high-reward than value investing because it is more speculative.
Important metrics
Even though growth investing is typically less focused on things like earnings multiples and sales multiples, it's still a good idea to keep these measuring sticks in mind when you are plotting your future investments. What constitutes an attractive earnings or sales multiple will depend on the industry that a company operates in, the age of the business, and other factors. Weighting the totality of these factors can help investors make sure that they are paying rates for sales and earnings growth that leave room for stock price growth down the line.
Price-to-earnings ratio (P/E)
The price-to-earnings ratio is calculated by dividing a company's stock price by its earnings per share in an annual period. In many cases, growth stocks will trade at price-to-earnings multiples that seem very high, and some companies may not yet be profitable. However, that doesn't mean that the stock is necessarily overvalued, because earnings performance over the long term will tend to be the key factor that drives a company's share price.
Price-to-sales ratio (P/S)
The price-to-sales ratio is calculated by divided a company's stock price by its revenue per share across a given annual period, and it's a particularly helpful metric when the company or companies you're looking at are not yet profitable or are going through a rough patch. An acceptable price-to-sales ratio will typically be judged in the context of other companies within its industry. Companies that operate in high-growth areas may trade at seemingly sky-high price-to-sales ratios because investors are putting a premium on the business' growth prospects.
Price-to-earnings-growth ratio (PEG)
The pace at which the underlying business is managing to expand earnings will also typically be a key factor in the valuation of a growth stock, and can be tracked in relation to the stock's price by dividing its P/E ratio by its reported or projected earnings growth rate across an annual period. Having a PEG ratio below one is often a sign that a stock is undervalued because it indicates that profits are expanding faster than the price of the stock in question. Earnings growth will not always track closely in line with share price appreciation, but the correlation tends to be strong over the long term.
How big is a growth stock's opportunity?
A product or company's potential addressable market is another helpful thing to look at when selecting growth stocks. By estimating how big the potential market for a given product or service is, you can start to form a better picture of a company's opportunity in a space and how seizing on this opportunity might be reflected in stock performance.
Large and expanding addressable markets can be fertile ground for rapidly expanding earnings, but it's also true that these appealing conditions can result in an influx of competition. If that happens and your company of choice in a given field isn't able to sufficiently differentiate its offerings, pricing wars can cause previously enticing growth prospects to evaporate.
Why growth is easier for smaller companies
Companies that are smaller have an easier time delivering growth -- in a relative sense, at least. A company that's recording $10 billion in annual sales will need to increase its business by another billion in order to deliver 10% sales growth, while a company that's recording $100 million in annual revenue would only need sales to increase sales by $100 million to deliver the same level of relative growth.
That doesn't necessarily mean that companies that have large market capitalizations can't be classed as growth stocks or continue to deliver fantastic returns. However, smaller increases in pure-dollar sales and earnings will move the needle to a greater extent with smaller companies. Small companies that are capable of delivering rapid growth also tend to be at greater risk of failure than larger stalwarts of industry, so it's important to understand that there are trade-offs.
Expecting a company like Apple, which already has one of the biggest market caps in the world, to triple in size within the next couple years probably isn't realistic unless it debuts new, revolutionary products that catch the market off guard. Meanwhile, a small-cap company operating successfully in a field such as e-commerce or education technology could feasibly see its valuation triple by simply continuing to expand its market reach or pulling back after a big research and development spending period -- and without the need for any additional product or service breakthroughs. This is one reason it's helpful to proceed with some basic target on how much growth you expect a business to achieve across a given time span -- and why your targets should vary depending on the underlying business and its market.
How to find large-cap growth stocks
Even well-run companies with strong product offerings tend to hit rough patches or have trouble sustaining growth over the long term. Part of this comes down to needing to deliver ever-increasing leaps and bounds of expansion in order to deliver the same rate of relative growth, but there are other issues at play.
Companies typically become established by tapping into large customer bases or markets and keeping their constituents satisfied. However, a strict adherence to what the current customer base is asking for and efforts to deliver iterative improvements can actually cripple a company's long-term growth trajectory. As detailed in Clayton Christenson's book The Innovator's Dilemma, the need to satisfy major customers can cause market-leading companies to miss disruptive shifts and be caught flat-footed as smaller, more nimble competitors swoop in to deliver changes that ultimately deliver greater value and reshape a given industry.
When looking for growth stocks among large, established companies, investors should seek businesses that are capable of meeting the needs of their current customers while also having independent units exploring other avenues. This helps to ensure that a company's future isn't completely tied to the whims of its current customer base and opens the door to creating and benefiting from new markets and trends. Investors should also try to make sure that these types of diversification efforts are being orchestrated without seriously damaging the core business of the day -- a balance that can be difficult to strike.
You'll want to look for companies with strong cash positions and little in the way of outstanding debts and liabilities. Sometimes companies that don't meet these criteria will still make for compelling investments. Taking on substantial debt to fund growth initiatives will be necessary in some cases, but businesses with big cash piles will generally be better positioned to take advantage of growth opportunities as they arise. Comparing a company's cash and short-term equivalent assets against its debts and operating liabilities will help you evaluate its financial position and its ability to fund new growth initiatives.
Investors can also look at P/E and PEG ratios in conjunction with analysis of whether a business has catalysts that will allow it to continue growing earnings at a relatively rapid rate. Taking a long-term view is important here because funding new growth projects will often be a significant drag on near-term earnings but can have a huge positive impact on performance over the long haul. Investors can also look for research and development spending listed in a company's quarterly reports and comments from management during earnings calls and other public events to help get a sense of what efforts businesses are making to better position for future growth.
A company can have a massive market capitalization, and still wind up being a great growth stock because it traded at an opportune price-to-earnings multiple and went on to deliver earnings growth that far surpassed the estimated rate implied by its stock price.
The importance of having a "moat"
Predicting the long-term performance of a stock is difficult, and it tends to be even more difficult with growth stocks because the underlying businesses are typically at earlier, less stable stages of their life cycles compared to the broader market. With that in mind, it's important to look for sustainable advantages that can help tilt the odds in your favor.
You'll want to look for stocks that have a moat -- a sustainable advantage that will help them defend their businesses against the competition. Just like the water-filled trenches that were employed as a line of defense for castle grounds in medieval times didn't mean that invaders couldn't get through, having a moat today or the potential of one tomorrow doesn't mean a business will be safe forever. It's a desirable characteristic nonetheless.
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How to find high-growth opportunities
Peter Lynch, famous for being one of the most successful investors ever, advocates a "go with what you know" strategy for finding high-growth stocks. This approach has sometimes been misrepresented as advice to simply invest in a product because you are familiar with it or personally enjoy it, but Lynch's actual prescription is much more sound than that. Lynch's oft-repeated investing maxim highlights an important competitive advantage that firsthand knowledge of products and services can grant the individual investor.
Here's a quote from his book One Up on Wall Street: "All along the retail and wholesale chains, people who make things, sell things, clean things, or analyze things encounter numerous stock-picking opportunities." As just one example, Lynch outlines how hundreds of thousands of people could have used data from their daily lives to get on the trail of one of his most successful stock picks: Pep Boys. He describes how Pep Boys' thriving business in the 1980s gave off a variety of signs that people with a connection to the business could have noticed and translated into a hugely lucrative investment move in the passage below:
Executives at Pep Boys, clerks at Pep Boys, lawyers and accountants, suppliers of Pep Boys, the firm that did the advertising, sign painters, building contractors for the new stores, and even the people who washed the floors all must have observed Pep Boys' success. Thousands of potential investors got this "tip," and that doesn't even count the hundreds of thousands of customers.
Investing in companies and industries that you have regular experience with can allow you to see shifts and trends before the broader market. Lynch estimates that the average person comes across a worthwhile investment opportunity in this manner between two and three times a year. If you think you may have identified such an opportunity, the next step is to do a deeper analysis. This will usually mean weighing the company's valuation in relation to its historical earnings and growth potential and also looking at its cash, other assets, and debt in order to determine whether it's in a good position to expand and deliver growth that surpasses the market's expectations.
Investors should look for businesses that offer products and services that are likely to see increasing demand and are relatively easy to recreate. Though McDonald's and Amazon might not seem like they have a lot in common on the surface, they share a characteristic that helped them build global empires and deliver stellar returns for shareholders: highly scalable businesses. These companies were able to expand the reach of their products and services at a rapid pace and in a manner that was cost effective and paved the way for huge profitability increases. Whether you're dealing with industries that you are intimately familiar with or those that you have less experience with, understanding industry trends plays an important role in identifying market opportunities and trajectories.
Tapping into trends for growth investing
Identifying trends that are seeing strong momentum but are still at relatively early stages and have plenty of room for continued expansion can help investors generate valuable investment ideas and open the door to big stock gains if you back the right players in a given space. With that in mind, investors will want to familiarize themselves with some of the hot trends that are shaping and influencing the business world -- and always be on the lookout for potential new trends on the horizon.
Growth in international markets
The U.S. has generally been the safest market to invest in, and there are some good reasons why many investors prefer to focus on American companies, but international investing can also be hugely rewarding and can offer greater growth. Rapidly developing economies like those in China and India present big growth opportunities for risk-tolerant investors. China and India, in particular, are regions that are worth paying close attention to because each of these countries has a population of well over 1 billion, fast-growing per-capita income and discretionary spending, and strengths in the technology and service sectors that could help continue their rapid economic rises.
Software-as-a-service (SaaS)
A transition away from one-time software sales and toward subscription-based models is helping tech companies deliver more profitable results and deliver them more reliably. Companies are able to charge more for their services over the long term thanks to SaaS models, and it can be easier to keep customers within a business' ecosystem and sell additional services without the need for big marketing expenses when users are on a subscription-based plan.
E-commerce
The explosive rise of Amazon over the last two decades exemplifies the significance of consumer spending transitioning from brick-and-mortar outlets in favor of online stores, and there's still plenty of growth potential in e-commerce that's yet to be realized. It's likely the customers will continue to do less shopping at brick-and-mortar retailers and more of their shopping online because of the increased convenience it affords, and the transition of small and medium-sized businesses to the online space is relatively young. E-commerce is booming outside of America as well, and the overall category has tailwinds that suggest big opportunities for investors.
Robotics and automation
The rise of automation and robotics is a trend that's already having major impacts across industries, but much of its revolutionary potential remains untapped. Automation has the potential to make manufacturing dramatically more efficient and unlock huge value, self-driving vehicles could revolutionize the personal and commercial transportation industries, and robotics advancements could bring about a wave of new products and services that have huge impacts for consumers, businesses, and government.
Artificial intelligence
Artificial intelligence has the potential to be the defining technology of the 21st century and power leaders in the space to incredible growth. A 2019 report from PricewaterhouseCoopers estimates that AI technology will generate $15.7 trillion in global economic value by 2030, and the intelligent sorting and utilization of data by machine systems is going to play a huge role in everything from robotics and automation to e-commerce and healthcare.
The war on cash
"The war on cash" is the broad term used to describe consumers moving away from cash in favor of digital payments and the efforts taken by businesses to accelerate the transition. There's already been a lot of progress made on that front, and it appears very likely that things will keep heading in this direction. Credit card companies, e-commerce players, and payment processors that have risen up to meet the needs of small businesses are all presenting digital solutions that can be more convenient and easier to track than regular cash payment systems.
Biotech
Demand for effective new pharmaceuticals and healthcare solutions will likely only continue to increase over the long term. Biotech companies produce biologic drugs -- treatments derived from complicated molecules that are grown inside a living organism. Some biologic drugs have proven to be exceptionally effective at treating diseases, and biotech companies are relatively shielded from the normal pharmaceutical-industry issue of patents expiring because recreating the complex molecules is much more difficult and competitors will not have access to the exact living organism that was used to create the molecule.
Marijuana
The marijuana industry has expanded at a rapid pace as the plant has been increasingly adopted for medical purposes and recreational use has been legalized or decriminalized by some governments. Recreational marijuana use is still illegal at the federal level in the U.S, but some analysts and industry watchers expect that the country will move toward legalization -- opening the door to huge growth. Even if federal legalization is a ways off or never materializes, there are opportunities in the domestic market in addition to nondomestic markets like Canada. Hemp strains that are very low in tetrahydrocannabinol (or THC, the key psychoactive ingredient in marijuana) and high in cannabidiol (CBD) are already legal in the U.S. market, and there's a booming market for oils and other products derived from CBD.
Image source: Getty Images.
A look at some promising growth companies
The table below presents a summary look at a handful of promising growth stocks:
Company | Key Growth Trends | Key Advantages |
|---|---|---|
Alphabet (NASDAQ: GOOG)(NASDAQ: GOOGL) | AI, international growth, SaaS |
|
Tencent Holdings (OTC: TCEHY) | AI, international growth, SaaS, payment services |
|
Take-Two Interactive (NASDAQ: TTWO) | International growth, SaaS |
|
Baozun (NASDAQ: BZUN) | International growth, e-commerce, SaaS |
|
Alphabet
Alphabet is already a massive company and has one of the biggest market capitalizations in the world. However, its dominance in search and digital advertising markets, leading mobile operating system, and wide range of innovative projects position the business to continue delivering impressive growth over the long term.
Alphabet's Google division has an effective monopoly in most geographic regions of the global search-engine market, giving it access to an incredible breadth of data and helping it establish an early leadership position in artificial intelligence. Google's Android OS is also the most used mobile operating system in the world, creating another huge source of valuable data and giving Alphabet ways to benefit from global growth for the number of internet-connected devices, an expanding population of mobile device users, and tech trends like the Internet of Things. These strengths suggest that Alphabet will likely be able to solidify its leadership position in AI and be one of the biggest proponents and beneficiaries of the tech's advancement over the next century.
Tencent Holdings
Tencent Holdings is a Chinese multimedia conglomerate that operates one of the country's most successful social media platforms and is making a big push into the AI space. If there's a promising growth trend, there's a good chance Tencent is either directly participating or has a stake in it through investments.
Like Alphabet, Tencent is already a massive company, but its strong collection of assets and growth initiatives suggest that its impressive run is just getting started. The company's WeChat service is sort of like a combination between Twitter and Facebook's core offerings but with a greater focus on online retail. Tencent also has a strong position in mobile payment, advertising, video games, streaming platforms, and other online media -- and it uses WeChat to tie many of its consumer-facing internet and entertainment businesses together.
WeChat has more than a billion monthly active users, and incredible engagement rates for the service combined with the company's rising cloud services offerings have Tencent sitting on businesses that generate and process huge swaths of data that should be useful in the development of artificial intelligence platforms and services. The company is still in the relatively early stages of building up this aspect of its business, and currently generates little in the way of direct revenues from AI service offerings, but it's making some big investments in the space and will likely be one of its big winners.
Take-Two Interactive
According to the Council of Europe's statistical yearbook, the total value of the global video game industry was $19.8 billion in 1993. A report from GlobalData states that the industry generated roughly $131 billion in 2018 and could climb to $300 billion in annual sales in 2025. Excluding the type of post-apocalyptic scenario that might serve as a setting or inspiration for many of today's video games, it's difficult to imagine a scenario in which interactive entertainment doesn't see big growth over the next 50 years.
Companies that continue to lead the field will likely deliver great returns for shareholders. With that in mind, Take-Two Interactive stands out as a player in the gaming space that has what it takes to go the distance. Take-Two franchises like Grand Theft Auto and NBA 2K have proven to be huge hits after being moved toward the games-as-a-service model and while that franchise is still very important for its performance, and its software will likely continue reaching a wider audience as the global gaming market expands. The company has done a commendable job in building up its cache of big franchise properties, and its relatively small size compared to competitors like Activision Blizzard and Electronic Arts suggest that its stock may have more room for growth.
Baozun
Baozun is a Chinese e-commerce company that provides Western brands with quick and easy solutions for establishing and scaling their presence in China's online retail market. China already has the world's biggest e-commerce market, and it continues to post above-average growth -- making it an attractive destination for companies looking to expand their international sales footprints.
Baozun provides online-retail-website creation and customization tools in addition to marketing, customer support, and order warehousing and fulfillment services. The company is the leader of its niche in the Chinese e-commerce market, and is partnered with Chinese e-commerce titans including Alibaba, JD.com, and Tencent in order to feature its customers' online-retail sales portals on their respective platforms.
The strength of Baozun's product offerings combined with its valuable partnerships suggest the company faces relatively little risk of disruption or being displaced by China's e-commerce titans, and the company's customers also face high switching costs once they are on board with its services. The country's massive population presents a huge opportunity as more of its citizens enter the middle class and per-capita discretionary spending continues to rise, and the quality of Baozun's servicing offerings (combined with the company's relatively small size) make it a smart play in China's fast-growing e-commerce market.
When to sell growth stocks
When searching for growth stocks, your basic goal will be to find stocks that trade at substantial discounts relative to their long-term earnings potential. That raises the question of what you should do when one of your growth stocks has seen substantial pricing gains.
If earnings or sales are still growing at a strong clip and the long-term outlook for the business hasn't changed, selling a stock because it has posted strong gains can be a big mistake. Companies that are winning tend to be winning for a reason -- they are delivering high levels of performance and may be in position to continue recording strong performance. For example, you would have seen fantastic returns if you bought Amazon stock in 1999 and held it through 2009, but your gains would have been dramatically higher if you held on for another decade.
Because growth stocks hinge on valuing performance that is difficult to predict, they tend to be much more volatile than stocks that are backed by more established and predictable businesses. This means that investors seeking big growth should have a tolerance for high volatility. Just because a stock has lost a quarter of its value in a short period of time doesn't mean that it won't rebound to post substantial capital appreciation.
Taking the time to reevaluate your holdings and determine whether they still look like good investments in relation to business developments and valuation changes is a smart and necessary practice. However, history indicates that a buy-and-hold approach to growth investing will work out better for most investors than trying to frequently flip your holdings or time the market.
Again, it's still important to periodically evaluate your investments in the context of the underlying business' growth outlook and new developments. If you think that a stock's growth story and potential have taken a meaningful turn for the worse, it may be time to cut your position and seek companies with better prospects.
Research and long-term vision are key for growth investors
With any investment, and growth stocks in particular, it's important to formulate a realistic thesis on where a company's business is heading and why that trajectory could create beneficial movement for its stock. Having a solid foundation of knowledge about a company and its industry is crucial to crafting a thesis that has predictive potential, so setting aside time to research your growth stocks is essential.
A given product might be the hottest thing in its category but account for a relatively small portion of its company's overall sales, making it unwise to invest in the business based on an optimistic outlook for the widget or service in question. Similarly, hot products and trends can fizzle out, and high-flying companies can be undercut by competitors. It's crucial to focus on finding high-quality businesses with sustainable competitive advantages. You won't score a hit with every pick, but having a well-informed and defined vision, a willingness to weather some volatility, and a long-term, buy-to-hold mind-set creates the potential to record tremendous returns with growth investing strategies.
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Keith Noonan owns shares of Baozun and Take-Two Interactive. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Apple, Baozun, JD.com, Netflix, Take-Two Interactive, and Tencent Holdings. The Motley Fool has the following options: short January 2020 $155 calls on Apple, long January 2020 $150 calls on Apple, short January 2020 $155 calls on Apple, and long January 2020 $150 calls on Apple. The Motley Fool has a disclosure policy.
This article was originally published on Fool.com
