Stock investing strategy – Growth investing

Stock investing strategy – Growth investing

In a nut shell….

Growth investors, invest in companies that exhibit signs of above-average growth. They don’t mind if the share price is expensive in comparison to its actual value. ‘Signs of above-average Growth’ is what growth investors try to spot. These signs gets revealed when you study the fundamentals. This is the exact opposite of ‘value investing’ approach. In a nutshell, the difference between ‘value’ investing and ‘growth’ investing lies in the methodology adopted by the investors. While the value investor looks for undervalued shares, the growth investor looks for shares with higher growth potential.

What exactly is ‘growth’?

Benjamin Graham defined a growth share as a share in a company “that has done better than average in the past, and is expected to do so in the future.” Any company whose business generates significant positive cash flows or earnings, which increase at significantly faster rates than the overall economy, can be categorized under ‘growth’. A growth company tends to have very profitable reinvestment opportunities for its own retained earnings. Thus, it typically pays little to no dividends to stockholders, opting instead to plow most or all of its profits back into its expanding business. Software companies are examples of growth oriented companies.

What’s the concept all about?

Investors who follow this strategy look for companies that exhibit huge growth in terms of revenues and profits. Typically, this set of investors looks for those in sunrise sectors (those in the early stages of growth) hoping to find the next Microsoft. A growth investor may look into the past year’s data to recognize the past growth rates and based on his studies about the industry’s potential and company’s prospects; try to estimate the future growth of the company. Investors look to spot a company that grows at minimum 15% annually. If a stock cannot realistically double in five years, it’s probably not a growth stock. That’s the general consensus. This may seem like an overly high, unrealistic standard, but remember that with a growth rate of 10%, a stock’s price would double in seven years. So the rate growth investors are seeking is 15% per annum, which yields a doubling in price in five years.

What does a Growth Investor look for in a stock?

Low dividend yields, high price-to-earnings ratio or high sales-to-market capitalisation ratio or a mix of all. For identifying stocks with high potential, growth investors look at key variables such as rate of growth in per share earnings over the last five-10 years, expected growth in earnings over the next five years or so, operating and net profit margins and business efficiency. A growth investor would target a company that’s growing at 15%-40% year on.

On a macro level, factors such as the stage in business cycle in which the industry operates, its relative attractiveness, and the positioning of the company in the competition matrix form part of the investment analysis. They then look at the current price and determine if it reflects the growth potential of the company’s business.

Growth – the risky strategy.

As growth investing often involves taking exposure to companies that trade at high valuation levels, the downside risk is relatively high. Sometimes, owing to their unproven business models, these companies could be sensitive to changes in market movements and business cycles.

Is a sky rocketing share a growth share?

Not necessasarily. Share prices can move up due to various reasons including fraudulent practices. High price is never a criteria for spoting a growth share. What matters is the rate of growth in the past years and the future prospects of the industry in which the company is in.

What are the sources to find Growth shares?

The best method is to do your own research. Most growth stocks can be spotted in the small cap and mid cap indexes. It is the growth rate that finally makes them large caps. Try to spot new companies that come up with   innovative ideas – for example in medical Pharma industry.  Watch companies that have grown from small cap to mid caps. Watch companies that breach all time high levels. Investigate why the prices sky rocketed.   You may also validate shares of Industries that are currently facing market overreaction to a piece of news affecting the industry in the short term and try to spot one.

Is this approach popular?

Yes. If warren buffet is popular for his value investing strategies, Peter lynch is one of the greatest growth investors. Both he strategies are being used by investors according to market conditions worldwide.

What are the Pros and cons of  Growth investing?

• Pros:The biggest advantage of this approach is Potential for incredible returns in a short period of time
• Cons:On the negative side, these shares carry the potential for huge losses.
• Market downturns hit growth stocks far harder than value stocks.
• Failure to relate the stock price to the company value leads to purchasing overvalued stocks
• Hot stock tips, rumors, hype, and market hysteria are not reliable sources of information to act upon

Which is better? Value or growth?

Both has its pros and cons as mentioned in our lessons. In value investing, the investor has to ensure correct stock valuation as well as the right time of entry – both being equally vital as he would not like to get too early into a stock.

In growth investing, it is essential for the investor to identify businesses that face little threat of erosion so that earnings growth of those companies is not impacted. Growth investors are generally in for short time frame compared to value investors. In general, value stocks tend to hold up better during stock market downturns.

An investor having a high-risk appetite is more likely to choose a growth strategy. While a defensive investor would choose to take the value investing route.