As an investor, there's nothing more exciting than achieving your first bagger. The term, coined by legendary investor Peter Lynch, refers to a stock that has provided at least 100% returns (a two-bagger). Multibaggers, like the rare 100-bagger Tom and David Gardner recently experienced from their early investment in Amazon, are even more satisfying.
The key to that end is investing in growth companies. These are high-flying companies that are growing revenue at a faster clip than the greater economy and the average stock in the S&P 500. However, investing in growth companies requires a different mindset than index or value investing. Here are three investing tips that will pay off for growth investors.
Leave your emotions at the door
In a prior article, Motley Fool One analyst Morgan Housel described the perfect investor, Paul. Paul is optimistic and apolitical, loves history, golf, cooking, and reading on the beach. Before Motley Fool is inundated with emails asking for Paul's contact info "for a friend," I should disclose Paul is hypothetical -- and a total sociopath.
While the term "sociopath" typically conjures images of a serial killer (remember Showtime's Dexter?), being a sociopath has shown to be a positive trait for investing. And that's because sociopaths are not controlled by the emotions that hamper normal investors. Being unburdened from emotions during drastic pullbacks is required when investing in high-growth industries.
Behavioral biases like the disposition effect, the tendency of investors to sell winners too early and hold on to losers too long; myopic loss aversion, selling investments after a short period of underperformance; and framing dependence, where your risk tolerance decreases during market corrections, can harm future returns. In the absence of being a sociopath, the next closest thing is to monitor your emotions and ensure investment actions are free from emotional bias.
Ignore the price-to-earnings ratio, and focus on this instead
One of the first metrics investors are introduced to is the price-to-earnings ratio -- the share price divided by earnings per share over the past four reported quarters. Unfortunately, when it comes to investing in growth companies, the price-to-earnings ratio is one of the most flawed metrics for evaluation. You may have noticed that high-growth companies often have an extremely high P/E, or even a negative number, whereas a low metric is typically preferred.
It's often said that value investors are more concerned with the "P" (price) in P/E ratio, while growth investors are focused on the "E" (earnings). The problem with the P/E ratio, then, is it's a backward-looking metric, whereas growth investors are looking for a company whose metrics will be vastly different in the future. Growth investors need to look for companies working to grow their earnings.
Admittedly, this is more art than science, but growth investors should focus on revenue growth, earnings growth, and the PEG ratio more than the P/E ratio. Additionally, growth investors should pay careful attention to earnings calls and note any forward revenue and earnings guidance by management to ensure the company can continue to grow to support above-average valuations.
When swinging for the fences, prepare for strikeouts
Reggie Jackson, Sammy Sosa, and Alex Rodriguez are considered amazing power hitters. They share 1,867 home runs between them, and each would arguably be considered first-ballot Hall of Fame talent (if the latter two were not tainted by the steroid era). There's a third statistic these sluggers have in common: Each is in the top five players in all-time strikeouts. Investing is similar in this regard: If you're looking at investing in a portfolio of young, high-growth companies that have home-run potential, look forward to a few strikeouts.
At the risk of stretching this analogy, the key to a successful growth portfolio is multiple "at bats" -- which means growth investors should keep a diversified portfolio. High-growth companies tend to attract competitors hungry for new revenue, many of which are established blue chip companies with deeper pockets. Additionally, many young industries fade by the wayside as demand for their products is further disrupted. Keeping a diversified portfolio of growth companies should offset the damage of any one company's failure.
Jamal Carnette has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Amazon.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.