The chief reason to invest money in stock markets is to make more money. We know the higher the expected return, the higher the potential risk of investing could be. However, if you have your strategy in place, things will work out well for you. Among the several investing styles, one is growth investing. The growth investing strategy revolves around identifying newer, not-so-mature companies demonstrating higher than average growth in the future and then riding the upward trend to move with the growth of such companies.
What is Growth Investing?
Growth investing focuses on capital appreciation with the help of companies with a better than the average earnings growth rate. Such stocks are mistaken for overvalued stocks by few investors because of their higher price-to-earnings ratio. Because these companies are delivering high growth in business volumes and profits, they hardly shell out dividends to the shareholders; most often, they don’t. The primary reason for the same is because the company’s management believes that the company is in the growth stage; hence, ploughing the profits into the business may make more sense.
How does growth Investing work, and how do you identify growth companies?
Higher P/E Ratio (But Avoid Overvalued Stocks)
The growth companies typically have a higher price-to-earnings ratio (P/E ratio). Investors are willing to pay more than the industry benchmarks for growth stocks because they believe that they are paying for the future higher earnings as well as the higher-than-average earnings growth of the business.
Another reason for such a high P/E ratio is that these companies are in their growth stage and may have limited earnings. As these companies are currently small and young in their maturity curve, they may seem to demand higher prices than their earnings.
It can be tricky as stocks with very high P/E ratios are considered overvalued. Hence, additional analysis to understand and differentiate between overvalued stocks and high-growth potential stocks for the future is a must.
Dividend Payouts Are Limited or Absent Altogether
‘Growth stocks pay zero dividends because they want to multiply by reinvesting their earnings. Therefore, such companies prefer investing the profits in the business again, rather than paying it to their shareholders. In addition, these companies are in business expansion mode and have huge capital expenditure requirements yearly. Hence, such profits, if ploughed back into the company’s operations, help the management to manage the CAPEX requirements for future business expansion.
Higher Sales Growth and Large Headroom For Growth
One crucial parameter for any growth stock is that they have to be present in an industry which is supposed to have large enough headroom for growth. For example, Amazon 2008 was building the e-commerce market. It was a non-profitable, high-growth company when it started e-commerce in India.
Furthermore, it is one thing to participate in an industry with substantially large market size. But another critical thing to evaluate is to analyze the historical sales growth. A company must grow year on year in sales at a rate higher than the overall industry.
In addition to operating in a large market and high-growth industry, your company should also have an increasing market share. Market share of any business is the business of the company compared to the overall industry volumes. Therefore, market share analysis will indicate two things:
- How fragmented or competitive the overall industry is.
- Are the company’s revenues growing at a rate faster than the industry; only then will it capture market share year on year.
Strong Management and Leadership Team
Growth businesses are all about the prospect of the company. It may happen that there will be minimal historical information about the company to analyze, and you may have to place your decision on the management’s forecasts and promise to expand the business. You must evaluate the core team running the business operations and assess their caliber and capabilities to scale the company as promised.
What Are The Benefits Of Growth Investing?
There are many benefits of following the growth investing strategy. Here are some of the key benefits
A growth stock generates a comparatively higher return because of increased business growth, higher than the industry average return. These stocks tend to outperform the overall market because of the benefits of compounding in the long run and generating alpha returns for investors.
Growth stocks offer good diversification to the overall portfolio where a part of the portfolio can be invested in high-return, high-risk growth stocks to push the overall return profile of the portfolio higher.
Hedge against Inflation
Investing in growth stocks provides higher returns, so beating inflation is possible. The real return for your investments is adjusted by the rate of inflation in the country, i.e. real return is the overall return of the portfolio after subtracting the inflation rate in the country.
- Less day-to-day monitoring for the investors
Investing in growth stocks is a long-term play, and you may not need day-to-day monitoring and review. However, whenever the company publishes their results, you must review and realign your understanding of the growth story and, accordingly, rebalance your portfolio allocation, if needed.
The benefits above may help you tremendously if you choose to invest in growth stocks. However, among the rules of portfolio creation, one is due diligence. Investing without understanding the company’s core values and checking if the company meets your needs is a fool’s errand. So think before you start investing.