Definition
Growth investing is an investment strategy focused on capital appreciation. It is done by investing in companies expected to grow at an above-average rate compared to their industry or the overall market. Unlike value investing, which looks for stocks undervalued by the market, growth investing targets companies that offer strong earnings growth and the potential for substantial price increases.
What is growth investing?
Imagine planting a sapling in fertile soil and nurturing it as it grows into a robust tree. Growth investing is similar; it involves identifying companies like young saplings with the potential to grow significantly. Investors buy shares in these companies early, hoping their stock prices will soar as they expand and become more profitable.
Online retailer ASOS launched on the UK stock market in 2001 at £24 a share, and many investors got behind the business, recognising its significant growth potential. As ASOS expanded within the online fashion market, the investment appreciated substantially, rising to over £7,000 per share in 2018.
Characteristics of growth stocks
- Higher Earnings Growth: Growth stocks typically reinvest their earnings in the business, rather than paying dividends, to fuel expansion and innovation. For example, Ocado is known for continually reinvesting its profits into expanding its technology and warehouse capabilities.
- Market Leadership: Many growth companies are leaders in their sectors with unique products or services that give them a competitive edge. ARM Holdings, known for its semiconductor and software design, often leads the market due to its innovative technologies, which are widely used in mobile devices.
- Higher Price-to-Earnings Ratios: These stocks often trade at higher P/E ratios than the broader market due to their high growth potential. Stocks like Rightmove, which operates the UK’s largest property portal, often trade at higher P/E ratios due to expectations of continued growth in the online real estate market.
Benefits of growth investing
- Capital Appreciation: The primary benefit of growth investing is the potential for significant capital appreciation (the increase in the value of an investment over time). Stocks of high-growth companies can increase in value quickly as the companies expand.
- Compounding Returns: Investing in growth stocks can lead to compounding returns (your initial investment earns money, and then those earnings are reinvested to earn even more) if the companies continue to grow and reinvest earnings effectively.
Risks of growth investing
- Volatility: Growth stocks are typically more volatile than value stocks, meaning their prices can fluctuate widely in short periods.
- High Valuations: Because these stocks are priced based on future potential, they are susceptible to steep declines if the anticipated growth does not materialise. Companies like Deliveroo were initially valued based on high growth expectations. If such companies fail to meet these expectations post-IPO, their stock prices could decline steeply.
How to identify growth stocks
- Strong Revenue and Earnings Growth: Look for companies with a consistent record of high revenue and earnings growth.
- Innovation and Market Potential: Companies that are innovators in their field or have products that open up new markets have strong growth potential.
- Financial Health: Robust financials with manageable debt levels are crucial as they allow a company to invest in growth opportunities without being over-leveraged.
Growth investing v value investing
While growth investing focuses on companies with potential for rapid expansion, value investing centres on finding stocks that are undervalued relative to their actual financial worth. The two strategies have different risk profiles and time horizons, appealing to different types of investors.
Growth investing is the sapling tree you hope will turn into a mighty oak. Value investing is finding a neglected but sturdy tree, pruning and nurturing it back to health for less cost.
Conclusion
Growth investing is a dynamic strategy that seeks to capitalise on companies with the potential for rapid expansion and significant market impact. While it offers the possibility of high returns, it also comes with high volatility and overvaluation risks. Investors interested in growth stocks must be prepared for a potentially bumpy ride. Still, they may find the rewards well worth the risks if they choose wisely.
