Unlike value investing which tends to yield low, reliable, long-term growth with minimal risk to capital, growth investing is a more aggressive approach to investing that looks for a faster payoff by buying in rapidly appreciating assets. For equity markets, this usually means buying stocks in companies with enormous growth potential.
There are many cases of aggressively appreciating stocks that have gone up in price by over 1,000% or even 5,000% in as little as a decade. Growth investors target these types of investments in an attempt to make money quickly by buying into a rapidly developing trend in a market or sector.
Growth Investing
Often seen as the other side of the coin in comparison to value investing, growth investing is a forward-looking strategy that tends to focus on the potential upside of a company (revenue, earnings, and management performance) and weighs this more heavily than the current performance of the company or lack thereof. Companies tend to exhibit the signs of increasing revenue as their businesses take off. In short, growth investors seek to buy companies that they expect to grow rapidly.
As mentioned previously, growth investors focus on the forward earnings of the company and expect these earnings to grow at an above-average rate in comparison to industry peers and the broader market. Growth stocks tend to trade at high multiples, specifically at a high price-to-earnings (P/E) ratio. This signals that investors are willing to pay a huge premium for earnings that have not been realized thus far by the company.
Ultimately, growth investors are seeking capital appreciation and will often focus on companies that do not pay dividends. This is because they expect the price of the stock to rise as the company executes its business plan, and in many cases that expansion will require capital. If companies are instead giving away capital in the form of dividends, that will make it harder for them to grow aggressively. Growth investors are willing to forego dividends and other forms of shareholder repayment as they prefer the companies to reinvest their earnings. They see this reinvestment as an opportunity for companies to compound their previous growth and help the company’s bottom line continue to grow rapidly as a result. Growth investors are often comfortable with companies taking on debt to fuel operations since they expect the companies to experience rapid growth and be able to cover debt expenses without experiencing any harm to the overall prospects of the business.
One sector of the market that tends to capture the attention of growth investors is “technology”. Tech companies tend to experience rapid growth at high levels that exceed the performance of the overall market. Companies of this sort include Apple (AAPL), Google (GOOG), and Ebay (EBAY). Technology companies have been known to grow revenues, increase cash flow, and produce earnings exponentially since the date of their IPO. Investors expect this performance to increase and as a result new investors are willing to pay higher premiums to own shares of the company. This increases the share price of the company and leads to higher valuations.
The biggest problem with growth investing is something called survivor bias. In hindsight, it sounds like investing in AAPL in 1990, for instance, was a much smarter thing to do than invest in value propositions like Coca-Cola (KO). However, hindsight is always 20/20 and several tech companies have disappeared. At several points in Apple’s history, investors and tech experts alike were waiting for Apple to go bankrupt, and this nearly happened in the 1990s on more than one occasion. A recommendation to buy Apple in 1996, for example, would have been laughed at by many experts in the computing industry. The dot-com bubble of the late 1990s is full of now-defunct companies for whom expectations were high and performance never appeared. Many growth investors lost substantial amounts of money when this bubble burst in 2000-2001.
As you may be thinking, growth investing does require some fortitude due to the high level of risk involved. Growth stocks tend to be volatile and can experience huge losses and gains within a single trading session. With that said, it is advisable that investors who are risk adverse and prefer companies with proven track records and tangible value to avoid growth stocks.
Summary
Developing an investing style is more of an art than a science and it requires an individual to do a significant amount of self-assessment before deciding on a particular style. For more on how on self-assessment, take a look at the “Trading Psychology” articles at Zolio’s Learning Center.
An investing style should mirror one’s overall personality since investors must be comfortable with their strategy before executing it. Therefore, it’s important to consider your risk tolerances, preferences, and overall views on corporate financial performance before deciding on an investment style. Value and growth investing both have their advantages based on your views of the market and overall investment thesis.
- Value investors seek to purchase stocks trading below their intrinsic value. (In plain English, value investors seek to buy something for less than it is worth, tantamount to shopping on sale)
- Growth investing is a forward looking strategy that tends to focus on the potential upside of a company (revenue, earnings, and management performance) and weighs this more heavily than the current performance or lack-thereof of the aforementioned.