What Is Growth Investing?
Growth investing is an investment style and strategy that is focused on increasing an investor's capital. Growth investors typically invest in growth stocks—that is, young or small companies whose earnings are expected to increase at an above-average rate compared to their industry sector or the overall market.
Growth investing is highly attractive to many investors because buying stock in emerging companies can provide impressive returns if the companies are successful. However, such companies are untried, and thus often pose a fairly high risk.
Growth investing may be contrasted with value investing.
- Growth investing is a stock-buying strategy that looks for companies that are expected to grow at an above-average rate compared to their industry or the broader market.
- Growth investors tend to favor smaller, younger companies poised to expand and increase profitability potential in the future.
- Growth investors often look to five key factors when evaluating stocks: historical and future earnings growth; profit margins; returns on equity (ROE); and share price performance.
Understanding Growth Investing
Growth investors typically look for investments in rapidly expanding industries (or even entire markets) where new technologies and services are being developed, and look for profits through capital appreciation—that is, the gains they'll achieve when they sell their stock, as opposed to dividends they receive while they own it. In fact, most growth-stock companies reinvest their earnings back into the business, rather than pay a dividend to shareholders.
These companies tend to be small, young companies (or companies that have just started trading publicly) with excellent potential. The idea is that the company will prosper and expand, and this growth in earnings or revenues will eventually translate into higher stock prices in the future. Growth stocks may therefore trade at a high price/earnings (P/E) ratio. They may not have earnings at the present moment but are expected to in the future. This is because they may hold patents or have access to technologies that put them ahead of others in their industry. In order to stay ahead of competitors, they reinvest profits to develop even newer technologies and patents as a way to ensure longer-term growth.
Because investors seek to maximize their capital gains, growth investing is also known as a capital growth or a capital appreciation strategy.
Evaluating a Company's Potential for Growth
Growth investors look at a company's or a market's potential for growth. There is no absolute formula for evaluating this potential; it requires a degree of individual interpretation, based on both objective and subjective factors, and judgment. Growth investors may use certain methods or criteria as a framework for their analysis, but these methods must be applied with a company's particular situation in mind: specifically, its current position vis-a-vis its past industry performance and historical financial performance.
In general, though, growth investors look at five key factors when selecting companies that may provide capital appreciation. These include:
- Strong historical earnings growth: Companies should show a track record of strong earnings growth over the previous five to 10 years. The minimum earnings per share (EPS) growth depends on the size of the company: for example, you might look for growth of at least 5% for companies that are larger than $4 billion, 7% for companies in the $400 million to $4 billion range, and 12% for smaller companies under $400 million. The basic idea is that if the company has displayed good growth in the recent past, it’s likely to continue doing so moving forward.
- Strong forward earnings growth: An earnings announcement is an official public statement of a company’s profitability for a specific period—typically a quarter or a year. These announcements are made on specific dates during earnings season and are preceded by earnings estimates issued by equity analysts. It’s these estimates that growth investors pay close attention to as they try to determine which companies are likely to grow at above-average rates compared to the industry.
- Strong profit margins: A company’s pretax profit margin is calculated by deducting all expenses from sales (except taxes) and dividing by sales. It’s an important metric to consider because a company can have fantastic growth in sales with poor gains in earnings—which could indicate management is not controlling costs and revenues. In general, if a company exceeds its previous five-year average of pretax profit margins—as well as those of its industry—the company may be a good growth candidate.
- Strong return on equity (ROE): A company’s return on equity (ROE) measures its profitability by revealing how much profit a company generates with the money shareholders have invested. It’s calculated by dividing net income by shareholder equity. A good rule of thumb is to compare a company’s present ROE to the five-year average ROE of the company and the industry. Stable or increasing ROE indicates that management is doing a good job generating returns from shareholders’ investments and operating the business efficiently.
- Strong stock performance: In general, if a stock cannot realistically double in five years, it’s probably not a growth stock. Keep in mind, a stock’s price would double in seven years with a growth rate of just 10%. To double in five years, the growth rate must be 15%—something that’s certainly feasible for young companies in rapidly expanding industries.
You can find growth stocks trading on any exchange and in any industrial sector—but you’ll usually find them in the fastest-growing industries.
Growth Investing vs. Value Investing
Some consider growth investing and value investing to be diametrically opposed approaches. Value investors seek "value stocks" that trade below their intrinsic value or book value, whereas growth investors—while they do consider a company's fundamental worth—tend to ignore standard indicators that might show the stock to be overvalued.
While value investors look for stocks that are trading for less than their intrinsic value today—bargain-hunting so to speak—growth investors focus on the future potential of a company, with much less emphasis on the present stock price. Unlike value investors, growth investors may buy stock in companies that are trading higher than their intrinsic value—with the assumption that the intrinsic value will grow and ultimately exceed current valuations.
Some Growth Investing Gurus
One notable name among growth investors is Thomas Rowe Price, Jr., who is known as the father of growth investing. In 1950, Price set up the T. Rowe Price Growth Stock Fund, the first mutual fund to be offered by his advisory firm, T. Rowe Price Associates. This flagship fund averaged 15% growth annually for 22 years. Today, the T. Rowe Price Group is one of the largest financial services firms in the world.
Philip Fisher also has a notable name in the growth investing field. He outlined his growth investment style in his 1958 book Common Stocks and Uncommon Profits, the first of many he authored. Emphasizing the importance of research, especially through networking, it remains one of the most popular growth investing primers today.
Peter Lynch, manager of Fidelity Investments' legendary Magellan Fund, pioneered a hybrid model of growth and value investing, which is now commonly referred to as growth at a reasonable price (GARP) strategy.
Example of a Growth Stock
Amazon Inc. (AMZN) has long been considered a growth stock. In 2020, it is one of the largest companies in the world and has been for some time. As of March 31, 2020, Amazon ranks in the top three U.S. stocks in terms of its market capitalization.
Amazon's stock has historically traded at a high price to earnings (P/E) ratio Between 2019 and early 2020, the stock's P/E has remained upwards of 70. Despite the company's size, earnings per share (EPS) growth estimates for the next five years still hover near 30% per year.
When a company is expected to grow, investors remain willing to invest (even at a high P/E ratio). This is because several years down the road the current stock price may look cheap in hindsight. The risk is that growth doesn't continue as expected. Investors have paid a high price expecting one thing, and not getting it. In such cases, a growth stock's price can fall dramatically.