The selection of stocks is one of the most vital steps before delving down to the world of the share market. A person can generally enter the share or stock market through two steps. One through the primary market and the other one directly into the secondary market. In the primary market, the investor needs to apply to the IPO (Initial Public Offering) of the company and if s/he is being issued the stocks of the company through the IPO, then the secondary market can be entered in order to sell the stocks issued to him/her. The other way to enter the share market is directly buying the shares of a company in the secondary market. In such circumstances, the investor is required to have a certain amount of capital to invest.
However, the selection of a company is not that easy when it comes to investing. An investor needs to go through a thorough fundamental analysis of the company if s/he wants to be on the safe side in the long run. An investment done without such analysis can go in vain if the company goes bankrupt because it was obvious that the investor had no prior knowledge of its fundamentals before the investment. The investor can decide whether s/he wants to go with the growth investing strategy or the value investing strategy based on his/her preference. However, in this article, growth investing strategy will be explored in detail along with the traits the growth stocks carry.
What is Growth Investing?
Growth investing is a strategy that focuses on the capital appreciation of investors rather than regular dividends. So, the capital invested by a certain investor will hike along with the rise in stock price and an investor can bag the profit with the difference between the amount that s/he had invested and the price that is currently trading on the stock market. The investors who adopt the strategy of growth investing are basically known as the growth investors. Such growth investors pick up the company that is exhibiting above-average growth. Those companies generally possess a way higher price-to-book ratio and price-to-earnings ratio. Growth investing completely contrasts with value investing which will be discussed in the later section of the article.
The one thing that growth investors need to keep in mind is that when they pick the stock of an emerging company in the hope that they will receive a higher and impressive return, such companies generally possess higher risk because they are not really tested in the long run, and they have just started to emerge. So, the strong fundamentals of the company are required to justify whether the investment is really fruitful or not. The foremost aim of growth investing is to enjoy a higher rate of return. So, instead of allocating the money where an investor gets the annual return of 10-12% on a Fixed Deposit (in the case of Nepal), they try to find out the company which provides them with higher return and invest in such companies. The investor’s capability of tolerating the risk is vital in a growth investing strategy.
Growth investors typically pick up the company in the industry which is growing at a fast pace where there is huge potential of growth in the coming future and new enhancements with technologies and services are being utilized. The majority of growth stocks pay less to zero dividends, so when the share price reaches way higher and before it dips down for correction, the investors book out the profit. On the contrary, the investors adopt a holding strategy when they select dividend-paying stocks because such companies have an excellent record of paying regular annual dividends. The other reason that investors do not enjoy the dividend in growth stocks is the reinvestment of profit by the company back into its business for further expansion instead of paying it to its shareholders.
Examples Illustrating Growth Investing Strategy
As mentioned earlier, a growth investing strategy involves the selection of growth stocks. Let’s take a look at how some of the investors could have been largely benefitted through the growth investing strategy.
Netflix, Amazon, Apple, and Facebook are some of the famous growth stocks on the global scale. Let’s suppose, as a growth investor, you selected Amazon as your next growth stock a few years back after doing proper analysis of the company knowing that online shopping would boom due to the emergence of the internet and technology in coming years. You had bought 1,000 shares of Amazon on 01 February 2016, when the stock price of the company was trading around $474 – $581. Let’s say, you managed to buy the shares at the price of $550. Now your initial investment would be 1000*$550 = $550K. Moving forward to the time of the year 2021, you decided to sell your stocks. On 1 April 2021, you checked out the stock market to find out the price of Amazon and you found out that it was trading in the range of $3232 – $3525. Suppose, you managed to sell your 1000 stocks at $3500 on that specific day. If we look at the return on investment, it is humongous. Consider some deductions on commissions and without the addition of any dividends (because of the growth stock), the return on investment would be approx. 535%. This is the reason why most people prefer growth stocks due to their huge returns. Similar cases can be seen with the stocks such as Apple and Netflix as well.
However, you need to keep in mind that these growth stocks are more volatile showing higher highs and lower lows in the share market compared to the steady movement of value stocks. Also, the investor needs to have the proper strategy of entering the market at the right point in time. S/he should not buy the stocks at their peak price or when the stock is overvalued. Instead of it, the right time to enter must be considered by letting the stock come down to its correction point so that investors could enjoy the proper profit. If s/he does not apply such tactic, they would buy the shares at a high price and the profit margin would be low if compared to the profit margin when they would have bought the stock at a low price considering the stock movements in the market.
Taking insight from one of the many investments from the father of value investing ‘Benjamin Graham’, when Benjamin was 50 years of age, he purchased $712,500 worth of shares in the company named GEICO (The Government Employees Insurance Company). Before the investment, he had analyzed the company and found out that the price was moderate in relation to current earnings and the asset value. During the post-World War II inflation losses, he took advantage of the panic and that was the moment when he made the purchase at a 10% discount to book value of Geico. By the time he reached the age of 79 in the year 1973, the aggregate profits from Geico alone surpassed the total gains he had received from all the other companies over the past 20 years. This is one of the many incidents to represent the huge potential of growth stocks.
Growth stocks provide the investors higher rate of return if entry and exit from the market are done in a proper strategic manner. Further, lower or no dividends could be enjoyed. On the contrary, the rate of return is consistent, and investors enjoy good dividends in value investing because they can be considered as blue-chip companies. There are some characteristics that growth stocks possess and those are the traits that growth investors try to look out and analyze before the selection of the growth stocks.
Characteristics of Growth Stock
1) Low/Zero Dividends
One of the very common characteristics, the majority of growth stocks provide very minimally to zero dividends. It is because these companies tend to retain their annual profit and reinvest for the better future prospect of the company instead of paying out those profits earned to shareholders in the form of dividends. The very popular names in the global market that had never paid any dividends to its shareholders are Google and Amazon. This is the reason why the investors who have done investment in these companies make big chunks of money only through capital appreciation, not the dividends.
2) Higher EPS
EPS stands for Earnings Per Share and is calculated by dividing the company’s net profit by the total number of outstanding shares that the company owns. The dividend must be considered when calculating EPS and should be subtracted from the net profit of the company. Simply, EPS represents how much money an investor could make for each of the company’s stock s/he holds. For instance, if the company has an EPS of $9, it represents that the shareholders are making $9 for every stock of the company they own. Higher the net profit of the company, higher will be the EPS indicating the positive signal towards the company.
The growth stocks generally have higher EPS, as their profits grow faster than the market average. When the investors find out that the EPS of a certain company is growing rapidly over the past years, they will definitely create more demand for the stocks of that specific company in the share market, which ultimately leads to a rise in stock price again. The EPS of Amazon in 2019 Q3 was 193% higher than 2019 Q2, which was way higher than the industry standard, that’s why it is considered as a Growth Stock.
3) Higher P/E ratio
P/E ratio stands for Price to Earnings ratio and is calculated by dividing the market value per share of the company by its EPS. Simply, it represents the amount of money that an investor is willing to put for per dollar earning of the company. For instance, if the company has a P/E of 25, it means that an investor is willing to put $25 in the company to receive a dollar of the company’s earnings. Growth stocks are expensive stocks because they have a higher P/E ratio, indicating that investors are willing to pay higher in order to receive the stocks of the company. The P/E ratio of Tesla in October 2020 was a whopping 875, which was way higher than the 40 P/E of S&P 500. This is because investors are putting more money into owning the Tesla stock in the hope of exceptional future growth as we are moving more towards electric vehicles in the coming future.
4) Competitive Advantage
The companies reflecting the trait of growth stock do have some competitive advantage over other companies in the market. This is the reason why they experience such rapid growth over the years. Having competitive advantages provides the company with Unique Selling Proposition (USP), that their competitors lack. This is why they grow better ultimately leading to more attraction of shareholders in the market.
5) Better Long-Term Returns
As mentioned above, the growth stocks pay less to no dividends, there is less possibility of gaining a high amount in the short run. However, if we take a look in the long run, the scenario is completely opposite. The substantial revenue can be gained in the long run through capital appreciation, as the company experiences multi-fold growth over the years.
6) Level of Uncertainty
All the investments have a certain level of risk factor. Growth stocks are a very attractive option, and they tend to be favorable in the long run as well, however they possess a certain level of uncertainty in the short term, which leads to the high-risk factor. It is because the blue-chip stocks are not so impacted by the bearish and bullish trend in the market when compared to growth stocks. Growth stocks are the ones that the market mostly hits with lows and downs. However, in the long run, growth stocks always seem to favor investors. In rare cases, the investor incurs heavy losses when the company underperforms and fails to deliver as per the expectation.
An investor must always choose the growth stocks with strong fundamentals and those showcasing positive strength in the long run. Some tips to choose good growth stocks are mentioned below.
Tips to Select Good Growth Stocks
1. Select the growth companies that have a strong management team and good leaders. Bill Gates, Steve Jobs, and Elon Musk can be taken as the example of great leaders who constituted strong management teams surrounding them.
2. Select the stocks that have outperformed the overall market return, or the industry return over the past years. Considering the last 2-3 quarters might not be enough, have a look on a big scale. For instance, return over the past 2-3 years, if it delivered high returns consistently over the years, then you are good to go.
3. Select the company that has experienced consistent cash flow growth over the past 5-6 quarters. This can be easily analyzed through the balance sheet of the company.
4. Select the growth stocks when they are fairly valued. Try to avoid buying the stocks of such a company when the price is at its peak. Instead, let the stock price be corrected and hit a certain low point. In such a scenario, you will be paying a certain amount of less money than you would have paid when it was at its peak. And once the market continues to grow, you can book a fair amount of profit.
5. Select a company with strong fundamentals: strong balance sheet, income statement, and financial ratios.
6. Choose the growing company which has a clear competitive advantage over others in the market. For instance, Apple vs other smartphone manufacturers.
7. Try to find out the companies with at least double-digit growth in sales over the past few years.
8. Select a company with a large target market and loyal customers. Apple would not have reached this level of success if it would not have a large target audience and a loyal customer base.
Growth Investing + Value Investing: Is it the best approach?
Growth Investing differs from value investing on a certain aspect, illustrated below in a tabular format.
|Growth Investing||Value Investing|
|⮚ Finding the company that is expected to grow faster than the market in the future.
⮚ Growth stocks: Less to zero dividends.
⮚ Generally high PE ratio.
⮚ Stocks are overvalued in the contemporary context.
⮚ Have relatively high volatility in the market.
⮚ Growth stocks signify emerging companies. E.g., Tesla
|⮚ Identifying the company that is undervalued, stock prices being lower than their fundamentals.
⮚ Value Stocks: Good return on dividends on an annual basis.
⮚ Generally, low PE ratio.
⮚ Stocks are undervalued in the contemporary context.
⮚ Have minor volatility if compared to growth stocks.
⮚ Value stocks signify well-established companies. E.g., Bank of America
You May Be Interested In: Value Investing & The Investment Discipline
Thus, growth stocks are more volatile in nature and fluctuate often along with the market sentiments and if the company is not able to keep with the growth expectation, there is a high risk of capital depreciation instead of its appreciation. Further, investors can not enjoy the dividends from growth stocks that value stocks tend to provide. On the contrary, value stocks are less volatile in nature and the investors can enjoy a good amount of profit through regular dividends even though the capital appreciation is not that significant compared to the growth stocks.
Value investing along with growth investing can be considered as one of the approaches to be on the safer side. It is because if some negative news arrives in the market regarding the growth stock that you have invested your hefty amount on, it is for sure that stock will be impacted badly which will lower down your capital invested. In this scenario, value stocks play the perfect role to balance out your loss because they are comparatively stable in terms of market movement. Therefore, it could be used as the perfect tool for hedging under poor market conditions. However, it all comes down to the investor’s preference whether they want to go with growth or value stocks. To conclude, the hybrid approach constituting both the value and growth stocks has become quite popular. Hence, future investors could analyze the hybrid investment approach to find out whether it suits their risk potential along with the investment objectives.
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