3 Simple Reasons Growth Stocks Are Smart Investments

Many investors follow the advice of Benjamin Graham and Warren Buffett by buying value stocks, which have low multiples relative to their peers and the overall market. However, picking the right growth stocks -- which trade at higher multiples while growing their sales and earnings faster than their peers -- can also be a smart move for three simple reasons.

1. Cheaper stocks aren't always better

We can see the long-term differences between value and growth stocks by comparing McDonald's (MCD -0.38%) to Chipotle (CMG 3.22%). Over the past ten years, McDonald's stock rallied 265% -- a solid return for a blue-chip stalwart, crushing the S&P 500's 69% gain. But during that same period, shares of Chipotle soared nearly 640%. The reason was simple: Chipotle grew its earnings at a faster rate than McDonald's.

Image source: Chipotle.

The irony is that McDonald's once owned 90% of Chipotle, but divested that stake in 2005 to focus on its core brand. Chipotle went public in early 2006 at $22 per share, and immediately soared to the low $60s within a few months. Many value-minded investors avoided Chipotle, because its trailing P/E -- which bounced between the 50s and 60s -- looked too expensive. Those investors likely preferred McDonald's, which traded between 15 to 19 times earnings and was in-line with the average P/E of the S&P 500.

However, those myopic investors didn't see that Chipotle's valuations were easily justified by its earnings growth rate, which was higher than its P/E ratio. Chipotle grew its adjusted earnings 94% in 2006 and 66% in 2007. McDonald's earnings rose 39% in 2006 but fell 30% in 2007. Chipotle repeated that impressive earnings growth over the following years, and it handily outperformed its former parent company.

2. Huge price growth beats dividends or buybacks

Companies that trade at low multiples because they're running out of room to grow often spend their free cash flow on dividends and buybacks to keep shareholders happy. Meanwhile, companies that are still growing prefer to reinvest that cash into the business, which generates higher sales and earnings to boost stock price.

For example, Facebook (META -11.79%) -- which more than tripled from its IPO price of $38 in just over four years -- has no plans to pay dividends or buy back stock. It would much rather use its cash to widen its moat with investments like Instagram, WhatsApp, and Oculus VR. These acquisitions can help the company keep growing after its core user growth peaks, and that fresh revenue might generate much more value for its investors.

3. Riding hot and disruptive trends

Many growth companies grow by riding disruptive trends that knock out former market leaders. In restaurants, "bistro-like" quick-serve chains like Chipotle and Panera Bread lured diners away from McDonald's and other fast food chains. In retail apparel, "cheap chic" players like H&M and Forever 21 wreaked havoc on higher priced retailers. Amazon's growth turned the entire retail sector upside down.

Image source: H&M.

In mobile devices, Apple wiped out mobile heavyweights Nokia and BlackBerry. Disruptive trends can also grow out of niche markets -- GoPro (GPRO -3.11%) created a niche market for action cameras, while Fitbit (FIT) did the same for fitness trackers.

As long as these companies can keep expanding and disrupting additional markets, they can continue growing and widening their moats. But if they fail to diversify and widen their moats before sales of their core products slow down, the fall can be swift and brutal. That's why shares of GoPro and Fitbit have respectively plunged 40% and 50% since the beginning of the year.

But caution is advised

Investors should be careful when investing in growth stocks. True growth stocks post higher sales and earnings growth than industry peers, and have solid plans to maintain that growth over the long term. They shouldn't be confused with "cult stocks" that lack the fundamentals to support their explosive price growth. 

What's more, as growth stocks climb, analyst expectations usually rise. If a company eventually misses those expectations and runs into trouble, the stock will likely drop on the notion that its growth story has ended. That's what recently happened to Chipotle after food safety issues caused its sales to slide.

Therefore, investors should understand what drives a company's growth, how wide its moat is, and whether or not it can diversify into new markets to keep growing. Answering those questions might help you find solid growth stocks that can outperform the broader market.