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Growth investing is a popular investment strategy that has been used by investors for decades. It involves buying and holding stocks of companies with the potential for above-average earnings growth. These companies may be part of fast-growing industries and are often high-risk, high-reward investments.
While growth stocks can provide higher returns over time, they are also subject to volatility, making them suitable for long-term investors who can tolerate market fluctuations.
Here’s how you can identify growth stocks and make the most of growth investing.
How growth investing works
Growth investing is a strategy that aims to increase an investor’s capital by investing in companies with above-average earnings growth. Growth stocks have the potential to provide higher returns over a long period of time compared to value stocks, but they are also more prone to volatility. During market downturns, growth stocks can experience significant price drops, so it’s important for investors to plan for that.
Growth investors focus on a company’s or market’s growth potential and look for factors like strong earnings per share growth, profitability, revenue growth and efficient use of capital. However, some growth stocks aren’t profitable so investors will focus more on potential growth than actual profitability markers.
“Growth stocks tend to be high-risk, high-reward investments. To lessen the risk of investing in individual securities, it might make more sense to invest in a growth-oriented mutual fund or exchange-traded fund,” said Ted Rossman, Bankrate.com senior industry analyst. “And view growth stocks as a component of a broadly diversified portfolio that might also include other types of stocks as well as bonds, cash, real estate and/or commodities.”
What are the characteristics of growth stocks?
Here are the characteristics that growth investors look for:
High-growth industries: Growth investors tend to invest in companies that operate in industries that are expected to grow faster than others. Technology and healthcare are two examples of industries that are expected to grow faster than average. Growth stocks typically have high valuations.
Economies of scale and competitive advantages: Companies with competitive advantages like network effects, scale advantages and high switching costs could be more likely to weather market downturns. These are companies that can reinvest profits to grow faster than their competition.
High price-to-earnings ratios: Growth stocks can have higher price-to-earnings ratios than value stocks.
How to find growth stocks
To find growth stocks, investors should look for companies that have promising positions in emerging industry niches with the potential for long-term expansion. It is also important to understand the business model and future earnings potential of the company. For investors who don’t wish to choose individual stocks, there are plenty of growth exchange-traded funds (ETFs) and growth index funds to invest in.
Keep in mind growth stocks are generally recommended for long-term investors who can tolerate some volatility. This strategy is best suited for investors who have a long investment time horizon and have the ability to ride out short-term fluctuations in the market.
Growth vs. value investing
Growth investors focus on companies that have achieved above-average earnings growth and are expected to continue doing so. They target companies with promising positions in emerging industry niches, and are willing to pay a premium to invest in growth. While they may purchase a stock if it’s discounted, they are more interested in future potential than current stock prices.
Value investors, on the other hand, seek out undervalued companies based on a number of metrics such as price-to-earnings ratio, price-to-book ratio, price-to-sales ratio, price-to-cash flow ratio and dividend yield. They believe that paying a lower price for future cash flows leads to higher returns. Both strategies have the same goal of achieving higher returns but employ different approaches.
Historical data shows that value and growth stocks move in cycles, according to Kiplinger. While growth stocks did much better than value stocks in 2020, in 2022, they dropped. Overall, value stocks seem to be the long-term winner, at least according to Dimensional Fund Advisors, an index-investing specialist that looked at the returns of value stocks vs. growth stocks from 1927 to 2021.
Balancing a portfolio with other types of stocks and assets can help turn growth investing into a sustainable strategy. By buying stocks when they are down and holding on to them for the long term, investors can reduce the impact of short-term volatility and benefit from the potential upside.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.