What is growth investing? A strategy that focuses on high-growth companies in hopes for significant investment returns

Simon Chandler

Nov 25, 2020, 03:35 IST

What is growth investing? A strategy that focuses on high-growth companies in hopes for significant investment returns

Investing for growth is a high-risk but high-return strategy that targets fast-rising stocks.KAZUHIRO NOGI / Staff/Getty Images

Growth investing is a fundamental investing approach that focuses on buying stocks expected to rise at a faster rate than the market overall.
Growth stocks tend to represent new companies in emerging markets and innovative industries, like high-tech.
Growth stocks offer higher returns but greater risk, so investors must carefully research a company's fundamentals and competitiveness in its field.

Growth investing is an investment approach that targets stocks that provide a significantly higher average rate of return than the market in general.

Now, your gut reaction to the above might be, "Hm, isn't that the point of investing in general?"

Yes, in a way. But growth investing is distinct in that it focuses almost exclusively on companies and sectors that are on the rise — and in the fast lane.

"Growth investing refers to investing in those parts of the market which can offer above average rates of return and therefore provide an opportunity for investors to grow (sometimes significantly) their capital," says Niladri Mukherjee, the head of CIO portfolio strategy for Bank of America Merrill Lynch. "Broadly, it can refer to investing in asset classes like equities or in early-stage companies in the private markets."

The focus on early-stage or high-growth companies does admittedly carry its own risks, but when combined with diversification, growth investing can become a key part of an investor's overall strategy.

Growth investing basics

While some investors mainly seek income from their financial holdings, most invest for appreciation — an increase in their money. Growth investing is one of the key ways to accomplish this goal.

"Growth investing is the search for companies that are growing quickly and more than the market in general. As an example, a company that earned $0.50 per share last year but will earn $1 this year is growing rapidly and would therefore tend to sell at a premium to the market," says Steve Massocca, the managing director at Wedbush Securities.

Growth stocks tend to represent exciting, new companies in emerging markets and industries, and are therefore valued very highly. There lies the inherent risk: Growth stocks are expensive to buy and hold. Even so, dogged growth investors simply see the higher premium as the cost of entry for growth for years to come.

Another risk to keep in mind: Because growth companies are apt to reinvest earnings to grow the business and spur even more expansion, growth stocks typically do not pay dividends — that is, until growth slows.

In that way, growth investing may not be ideal for the risk-averse investor looking for quick returns. Instead, growth investing may be more suited for those with a higher tolerance for risk and a longer investment horizon.

What makes a good growth stock?

To transform growth investing into a sustainable strategy, investors must learn how to identify equities that have the most potential to become growth stocks. While the following list isn't exhaustive, here are the three important principles for spotting good growth stocks:

Look for new, high-rising industries: The first thing to do is to look for newer industries and sectors that are exhibiting stronger-than-average growth.

"Growth investing tends to live in newer industries where customer acceptance is growing from a very low level, say smartphones as a historical example. Growth stocks are identified by how fast their revenues and earnings are growing relative to the market," says Massocca.

It's obviously not enough for investors to identify growth sectors and then invest in any early-stage company they can find. It's also vital to do your homework on what any given company is doing, and on how they fit into their industry.

Evaluate future earnings power: Another important area to consider is the future earnings power of a company, meaning its ability to generate profits over the long term. This can be done by examining its return on assets (ROA), its return on equity (ROE), as well as its current revenues, assets, and profits.

"When selecting growth stocks, it is important to understand the business model of the company, [as well as] their earnings power into the future," says Niladri Mukherjee.

Assess the quality of senior management: Of course, it's not enough to simply look at a company's sector and its present-day financials. If you want a good idea of whether it really can grow healthily into the future, you'll also need to consider the quality of its senior management.

This means looking at its board and executives, checking their experience and track record. If there's really no one in senior management who has any substantial degree of experience, it may be risky to assume that the company will perform strongly and sustainably.

The power of growth funds

Aside from scouring for start-ups and emerging markets, one temptation may be to identify potential growth stocks by looking for initial public offerings. Such IPOs tend to be held by companies in high-growth sectors and may promise higher-than-average returns.

However, research suggests that IPOs aren't as profitable as many might assume, with historical data collected by the University of Florida's Jay Ritter showing that around 60% of IPOs have negative returns for five years following their openings.

In the face of such dangers, one safer option may be to invest in a mutual fund or ETF which tracks growth stocks and sectors, holding a variety of companies in its portfolio.

"An ETF provides a cost-effective way to get exposure to an index of growth stocks," says Niladri Mukherjee.

Some of the most popular growth ETFs include:

For example, the iShares Russell 1000 Growth ETF tracks around 500 of the best-performing large U.S. stocks. It recorded a return of 37.2% for the 12 months to September 2020, compared to a return of 13% and 6.6%, respectively, for the S&P 500 and the Dow Jones. That said, the NASDAQ rose by 45.8% over the same period, so not all high-growth funds may be more profitable than merely investing in a fund that tracks an index.

Likewise, here's a small selection of the most high-profile and best-performing growth mutual funds:

Growth investing vs. value investing

Both growth and value investing are approaches taken by appreciation-oriented investors. However, strategy-wise, growth investing is the opposite of value investing.

Both seek a high return on the invested capital. But while value investing seeks out companies that are underpriced relative to their intrinsic worth, growth investing is all about buying into promising companies with a stronger potential to rise even further.

Often, stocks are viewed as either "growth" or "value" stocks. Telling the difference between growth stocks and value stocks is fairly simple, and is usually based on not only rates of return, but also prices.

"Value investors are looking for companies that are trading cheaper than the market in general. Typical barometers are price to earnings and price to book. Stocks selling for less than book value attract value investors under the assumption that eventually, the market will recognize this discount and correct for it," says Massocca.

Compared to growth stocks, value stocks tend to have lower price-to-earnings ratios, which measure the ratio of a company's stock price to its earnings per share. Anything under 13 to 15 is considered relatively low, given that the average P/E ratio for the S&P 500 has historically hovered in that range.

With a value stock, an investor faces less of a risk of a sharp price collapse, in the event that a company underperforms or is confronted by bad news. There's also potentially more space for its price to rise.

"Long time tenants of investing hold that growth investing is riskier than value investing. As investors get older they tend to move from growth to value," says Massocca.

On the other hand, the efficient market hypothesis states that cheap-but-good stocks should be few and far between, or should exist only for a short time before the market inevitably corrects itself.

This is why it's important to balance value investing with growth investing since no approach on its own provides an easy way of reaping outsized returns.

Tips for investing for growth

There's never a 100% guarantee you'll consistently make a profit with growth investing, but there are a number of steps you can take to increase your chances.

Diversify: Just as it applies to investment in general, diversification is a key strategy in growth investing. A well-balanced and maintained portfolio of stocks will increase your exposure to reward while decreasing your exposure to risk. "Investors should keep a diversified exposure when investing in growth — different companies, industries, size, and liquidity. Investors should review the position size of these holdings as they can disproportionally add risk to the overall portfolio," says Mukherjee.
Go abroad: A smart growth investor looks to foreign and emerging markets, and thinks about placing their capital across a range of asset classes, not just equities. "Investors should keep a balance of domestic and international investments and have other assets in the portfolio such as fixed income and cash which can provide ballast when volatility strikes and risk assets like stocks decline in value," says Mukherjee.
Look for the potential for market dominance: One area where growth stocks dominate is the tech sector. The main reason for this is that the tech industry almost naturally produces disruptive products that enable their manufacturers to assume a position of market dominance.

"Growth stocks typically trade at a valuation premium to the market for reasons such as they possess higher earnings growth, have a unique product or business model, or are dominant in their industry," says Mukherjee.
Pick a good fund and be patient: Diversification is important, but few of us have the resources to hand-pick dozens of stocks ourselves. As such, the best way of diversifying is usually through an ETF or mutual fund.

It's important to note, however, that once you settle on a good fund you will need to be patient. Most of the top-performing growth funds do boast positive returns over the medium and long term, but you may need to wait at least a year or two before you see significant upside. This is particularly the case with growth investing, given that some prominent growth companies (e.g., Amazon) needed years before they could turn a profit.
Research, research, research: Research is vitally important if you want an informed idea of what to expect from growth investing. This means not only researching the fundamentals of any company you're going to invest in individually but also monitoring the wider economy for indicators of a favorable environment for growth investing (e.g., low interest rates).

This latter point is important. Growth stocks may be more likely to rise higher — or sink — when certain economic conditions are met, with low interest rates being an important indicator of a wider appetite for equities, for example.

The financial takeaway

Growth investing offers investors the opportunity to outperform the market, given its focus on companies that are showing signs of above-average expansion and profitability. This focus also comes with risks, with many IPOs actually losing money for investors.

It's because growth investing involves numerous risks that it may be a good idea for investors to turn to an investment manager — either a personal one (assuming they can afford it) or the professionals managing a growth-oriented mutual fund or ETF.

However, even without a portfolio manager, investors can make growth investing work for them so long as they do their homework and maintain a consistent strategy of diversification. By balancing their portfolio with other types of stocks, along with other assets, most investors should be able to turn growth investing into a sustainable strategy.