Few investment strategies hold the allure and potential of growth investing. Growth investors seek out the hidden gems, the disrupters and tomorrow’s pioneers. But the path to exponential returns is paved with volatility, demanding a stomach for weathering temporary setbacks.
So, what is growth investing, and what does it entail?
What Is Growth Investing?
Growth investing involves buying shares in companies expected to grow faster than the market’s average rate. These companies (growth companies) have the potential to outperform the market because of their anticipated bright future. Therefore, a growth investor’s primary objective is capital appreciation – profiting from the increase in a company’s stock price over time rather than receiving dividends.
Growth companies, and therefore growth investing, are often concentrated in innovative industries. The technology, e-commerce, healthcare and renewable energy industries routinely experience rapid changes and disruption, thus providing a hotbed for growth investors.
What Does Growth Investing Entail?
Although growth investing revolves around buying shares in companies with higher-than-average growth, other characteristics include the following.
No Dividend Payments
Growth companies don’t usually pay dividends to their shareholders…at least not at the start.
In the early stages, most growth companies don’t usually generate annual profits. But even if they did, every penny would be reinvested to fund future growth. Although these companies don’t distribute dividends to shareholders, investors are drawn in due to the potential for higher-than-normal investment returns.
Expensive stocks
Growth stocks usually have a recent history of exceptional growth and are expected to continue this growth into the foreseeable future. But these lofty expectations come at a cost, a very expensive one.
When investors talk about a stock being expensive, they don’t necessarily mean the price itself but the price relative to the company’s earnings. This relative “expensiveness” is captured by the company’s price-to-earnings (PE) ratio.
The PE ratio is a financial metric that tells investors how much the market would pay for £1 of a company’s earnings (profit). This relative measure is why a £500 stock can be considered cheap and a £5 stock expensive.
The higher the PE ratio, the more you pay for £1 of a company’s earnings. Growth stocks tend to have extraordinarily high PE ratios…sometimes they don’t have one.
High volatility
Growth companies are prone to wild swings in their stock price.
Delivering on ambitious plans and achieving high growth rates are the bases for investing in growth stocks. When growth companies beat analyst expectations, the stock price can shoot up 10, 15, or even 20% in a single trading session. Some may even climb more than that.
Missing these expectations, on the other hand, can lead to equivalent declines. If the company is young, burns through cash and doesn’t generate profit, the price declines can be even more severe.
Growth Investing Advantages and Disadvantages
Growth investing can be a rewarding strategy for investors willing to take on high risk for the potential of high returns. However, it requires careful consideration of a company’s fundamentals and the investor’s risk tolerance.
Here are some advantages and disadvantages of growth investing.
Advantage: Outperform the Market
Because they have high growth capabilities, growth stocks can massively outperform the overall market.
A recent example of this is NVIDIA.
From January 2023 to October 2024, NVIDIA’s stock price rose by a whopping 867%, fuelled by the company’s investment in and implementation of artificial intelligence (AI). For comparison, over this same 22-month period, the US stock market, as measured by the S&P 500, grew by 50%.
To clarify…the S&P 500’s 50% return in 20 months is exceptional, especially since it averages 10% annual returns over long periods. Although outstanding, it stands no chance against NVIDIA’s 867% return (in 22 months, let’s not forget).
Advantage: Extraordinary Long-Term Capital Appreciation
If you get lucky and pick a successful growth stock in its youth, you will accumulate life-changing amounts of money.
Finding, investing and holding on to shares in a young Apple, Amazon, or Microsoft would have produced extraordinary shareholder returns. At the time of writing, these companies have returned 214,881%, 209,977%, and 418,680%, respectively, since their shares began trading.
These are fantastic total returns and would have generated fortunes for early investors.
However, each company’s life has included volatile and tumultuous years. For example, Apple was 90 days away from bankruptcy in 1997. Growth investors must be okay with these situations when investing in young growth companies.
Disadvantage: Increased Likelihood of Investment Loss
Because growth stocks have high expectations of outperforming the market, there is a high probability they won’t.
Since high growth is the main driver for investing in growth stocks, when companies fail to meet expectations, the share price can nose-dive by crazy percentages. Some may fall 10, 20, or 30% in one day, with the declines continuing in the following days.
These price drops can leave investors with huge losses.
Disadvantage: Risk of Overpaying for Shares
Since some growth companies are unprofitable and have negative cash flows, estimating their intrinsic value can be difficult. Calculating what to pay for these companies would require additional assumptions, further complicating the valuation process.
Even if you arrive at an estimated intrinsic value using all available information on a company, the company may be overvalued. Ignoring this possibility and accumulating shares can hinder investment returns or result in avoidable losses.
Growth Investing vs Value Investing
Both growth and value investing can lead to profitable outcomes for investors, but the choice doesn’t have to be either-or.
Warren Buffett, arguably the most successful value investor, rightly pointed out that both strategies are intrinsically linked. In his 1992 letter to Berkshire Hathaway shareholders, Buffett said,
“In our opinion, these two approaches (value and growth) are joined at the hip: growth is always a component of the calculation of value, constituting a variable whose importance can range from negligible to enormous.”
In other words, you must make growth assumptions to estimate a company’s value. The growth rates used in the valuation process significantly impact the estimate of intrinsic value. Usually, the higher the growth rate, the higher the company’s value.
Additionally, growth stocks can occasionally enter value territory. Take, for example, the big US tech firms in 2022. When the market sold off, these companies came down from their highs to trade at prices at or below intrinsic value.
Meta Platforms is a prime example.
In October 2022, Meta fell to USD$89 per share, a price not seen since 2015. The company traded at a 10x PE ratio when its five-year average PE was 26x and its nine-year average was 45x.
Since then, Meta has climbed to several all-time highs, currently trading around USD$575 (22 Oct. 24). This represents a 533% increase since October 2022. The company’s current PE ratio is 29x.
So, not because a stock is considered a growth stock means it can’t become a value stock.
But instead of thinking of stocks as ‘growth’ or ‘value’, it’s best to think of them as ownership stakes in a company. You’ll focus more on the quality of the business and its ability to generate satisfactory shareholder returns.
Summary
Growth investing offers the potential for extraordinary returns by backing companies looking to shape the future. It’s a strategy that appeals to those with an eye for innovation and a tolerance for volatility.
By owning high-growth companies, investors may see their wealth multiply over time. However, the pursuit of these substantial rewards comes with risks.
Investors must be prepared for the possibility of overpaying for shares and facing steep declines when growth expectations are unmet. Growth investing requires careful research, patience, and a willingness to weather the ups and downs.
Ultimately, growth investing is not for the faint of heart. But for those willing to embrace its challenges, its rewards can be life-changing.
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