As an investor, it makes sense to consider the value of putting money into growth stocks. After all, growth stocks represent equity in companies that are expected to outpace their peers in earnings and stock performance.
While these stocks don’t usually pay a dividend, the capital appreciation returns can be exponential. Over time, as growth companies mature, they may decide to start paying dividends.
Five characteristics to look for in a potential growth stock investment are:
- A strong leadership team
- An industry poised for growth
- Commanding market share
- Strong sales growth
- A large target market
- Growth companies are expected to have earnings and stock performances that outpace their peers.
- Growth stocks provide short-term and long-term opportunities for investors.
- Traits to look for in growth companies include a strong leadership team and an industry with the potential for growth.
- Investors should also want to see a record of strong sales growth and a large target market.
- Avoid growth stocks that are overvalued.
5 Characteristics of Good Growth Stocks
When researching growth stocks, investors may discover that they're not all created equal. The good news is that this presents short-term and long-term opportunities for investing.
Winning growth stocks often share many of the same characteristics. These include a strong leadership team and solid growth prospects. Innovative ideas can be part of the mix. These and the other key traits detailed below can signal a stock that may be poised to take off.
1. A Strong Leadership Team
Growth companies focus on increasing their sales and profits. Therefore, the foresight and capabilities of the executive and management teams matter. Growing a company requires an innovative group of leaders. Without it, growth may not happen.
Growth investors seeking their next investment should look at companies where the executives and managers have good track records for success and noteworthy visions for where they want to take their organizations. Look for innovative thinking, as well. Steve Jobs and Bill Gates are vivid examples of innovative company founders.
You may have to examine the records of leaders before they joined a prospective company since growth companies can be young with no significant performance history to share.
While it may not be easy to spot the next great growth company or innovator, researching leadership teams can help. Don't get stuck with a company that follows the pack when you want one that leads it.
Great leaders have been known to post short-lived successes. Studying a company’s leadership team can weed out potential risks.
2. A Promising Growth Industry
Companies that plan to grow should be in industries where big growth is possible and perhaps already in evidence. Industries at the tail end of their growth trajectories aren't considered growth markets. For example, today may not be the best time to invest in a personal computer (PC) hardware vendor but it could be the right time to get in on a mobile app start-up.
3. Commanding Market Share
In addition to operating in a high growth industry, the company you choose should have a commanding market share. Market share is a company's total sales relative to the total sales of its industry. It's an indicator of how competitive a company is compared to others in the industry. A growing market share means growing revenues.
You may not want to invest in the third or fourth player in an emerging growth market. Nor should you want a one-trick pony. Investors should look for companies that will be able to sustain their competitive advantage. Is the company producing many successful products? Are there innovations that are making an impact? Or, does a company continue to ride its first achievement? These are questions investors need to consider.
Microsoft (MFST) has been a growth stock for decades. It continues to pursue new avenues for success and has the cash flows to invest in innovative products and services (such as cloud computing and gaming) with huge target markets.
4. Strong Sales Growth
The leadership team, industry growth prospects, and market share are prime considerations when looking for growth stock investments. Another key factor is a company's sales. Look for companies that are experiencing an acceleration in the growth of sales, revenue, and earnings over consecutive quarters.
Try to identify increasing sales growth connected to market breakthroughs or the start of a new management team's tenure. Be wary of companies that have irregular or slowing growth.
The faster the growth rate, the greater the likelihood that a stock's price will rise. After all, companies that are boosting sales and earnings are going to be attractive investments. When it comes to the performance of a winning stock, there isn’t any hard and fast rule. However, you may want to see it turn in double-digit growth rates.
Many high-flying growth stocks see triple-digit growth rates when a company is young. However, as a company and industry mature, sales can slow. Demand for a stock may decrease. Be diligent when assessing sales growth.
5. A Large Target Market
Companies don't get rich selling a niche product to just a handful of customers. For any business to grow, it needs a large target market of consumers to whom it can sell.
For growth investors, the companies that are serving huge markets are certainly ones to consider. The bigger the pool of potential customers, the greater the opportunity for the sales and revenue that drive growth. For example, consider Apple and the iPhone. Without its massive market, the iPhone may not have seen so much sustained success.
Avoid Overvalued Stocks
Growth stocks are attractive to many investors because of the potential they hold for increases in price. That doesn’t mean you should overpay for a growth stock simply to own it. Growth investors can use fundamental analysis ratios to compare a stock's intrinsic (or true) value to its market price. This can help them determine whether a stock is overvalued or undervalued.
Growth stocks that are overvalued can decline and eventually trade at a price that reflects its current fundamentals. This could be bad news for growth investors if they fail to do their research and buy high.
The price-to-sales (P/S) and price-to-earnings (P/E) ratios can give investors useful insight into a stock's valuation. A reasonable P/S ratio with the expectation for high sales growth can be a good sign for the future stock price. A flat P/E to forward P/E or a forward P/E that is below the historical average can also mean the stock has a great deal more room to move higher.
What Is a Growth Stock?
A growth stock is stock in a company that analysts project will experience growth in revenue and profits that's greater than the average for its industry. This growth will translate to an increasing stock price. Many investors own growth stocks for the return they hope to receive by selling them at a much higher price than their purchase price.
How Does Market Share Relate to Growth Stocks?
A company's market share is its total sales compared to the total sales of its industry. The greater the market share the better because market share is an indicator of revenue growth and competitiveness. Revenue growth and profitability can boost the price of a company's stock. Growth companies with good (and growing) market share may be a prime investment opportunity.
What Does It Mean When a Stock Is Overvalued?
A stock is considered overvalued when its intrinsic value is less than its market price. Some investors avoid overvalued stocks because they perceive that the stock will eventually drop in price to be more in line with the intrinsic value. Other investors simply want to own the stock and may not care that it's overvalued. Many investors have profited from buying stocks that are undervalued and selling when they rise. An undervalued stock has a market price that is less than the intrinsic value.
The Bottom Line
Growth investing can often be most attractive in a healthy economy where companies are benefiting from increased demand and a rise in corporate and consumer spending. However, certain key factors can help a growth company do well in all types of economic environments.
Broadly, companies that are seeing their growth accelerate will often see their stock go up as well. Not every growth company is the same, so it's important to assess risk and monitor your growth investments.
Growth investments can reap tremendous rewards. They also may pose some of the highest risks. Knowing how to identify the best ones can help investors narrow the growth stock universe and pave the way for a higher portfolio return.