What is “Growth Investing”?
Growth investing is a major investment approach that aims to appreciate investors’ capital over the long-term. It targets “growth companies” that have the potential to grow their earnings at a higher rate than the market and as a result are expected to deliver higher stock price returns. These could be smaller companies and/or businesses that have a competitive edge in their industry such as disruptive and unique product or service, patent, and highly efficient operational structure. Growth companies usually trade on higher multiples relative to the market and can be associated with higher levels of volatility. The growth style of investing is often contrasted with the “value investing” approach, which targets undervalued assets.
Key Learning Points
- Growth investing is an investment style that seeks to buy companies with high earnings growth potential
- The typical profile of a growth company is a disruptive business that offers unique products or services, possesses patents and operates in an industry with high barriers to entry
- Growth stocks typically trade at a higher multiples, for example on a price-to-earnings (P/E) basis due to forward-looking earnings expectations being priced in the current share price
- They are usually smaller entities that have higher upside potential relative to their more established peers – however, that comes at the expense of higher perceived risk
How Does Growth Investing Work?
The philosophy behind growth investing is to find companies that have a strong track record of increasing their earnings at a faster rate than the market rate and have the potential to continue in the same fashion. Investors are often willing to pay a higher price in order to gain exposure to these projected future revenue streams and as a result of that, growth businesses can trade on higher multiples than the market.
This style of investing usually fits with long-term investors who are comfortable taking higher risk and have no income requirements (no dividend requirement). Due to the nature of growth companies – disruptive businesses operating in a segment with higher entry barriers that offer unique products or services, they tend to be at an earlier stage in their development. That also allows them to be nimbler and have stronger abilities to adapt to a fast-changing environment.
Features of a Growth Stock
One of the most common features of growth stocks is that usually they do not distribute company profits to shareholders in the form of dividends. Instead, profits are reinvested into the business to fund research and development, enhancing production lines and operations. These firms tend to have very efficient business models and demonstrate healthy profit margins and strong return on equity. In terms of valuations, they normally trade at higher multiples relative to both the broader market and their industry peers, for example on a P/E basis.
The Bottom Line
As opposed to value investing, where investors try to establish the company’s intrinsic value and buy at a discount, growth investing focuses on strong future revenue generation and upwards earnings revisions. Growth stocks also tend to show higher beta and larger moves in their stock prices respectively. In order to achieve optimal portfolio diversification and risk-adjusted returns, investors could blend growth and value companies.