It's no secret why growth investing is appealing. The investment strategy that focuses on buying high-growth stocks for the long term can give investors the best chance of generating above-average returns.
As we've seen over the last 10 years, dozens of high-profile growth stocks have delivered returns of 1,000% or more, taking investments of $10,000 and turning them into at least $100,000. The market rally over the last nine years that's pushed the S&P 500 up four times from its recession-era bottom, has been driven largely by growth stocks, including the famous "FANG" group of tech stocks, which have posted eye-popping returns.
There are several characteristics that separate the best growth investors from the rest of the pack, but before we examine the four things top growth investors have in common, let's take a step back and define the key term here.
What is a growth stock?
In the simplest terms, a growth stock is a stock that investors expect to generate high revenue and profit growth, which will then lead to growth in the value of the company, and therefore the stock. Growth stocks are generally more expensive than the average stock, meaning they trade at a higher price-earnings ratio (P/E) -- the market value of a company's stock divided by its earnings per share. In other words, investors may pay more for a dollar of a growth company's earnings than they do with other stocks. This is often because growth stocks have little or no profits. Many of them are young companies and are spending capital on growth drivers like research and development or marketing, investing to grow revenue and market share rather than to maximize profitability.
Investors put a premium on such companies because they believe that growth will transform them into a dominant brand or industry leader. Amazon (NASDAQ:AMZN), for instance, has been one of the best growth stocks of the last 20 years, largely because the company continues to invest in emerging markets and technologies like cloud computing, its voice-activated assistant Alexa, and faster delivery. Though Amazon today is one of the most valuable companies in the world, it's still treated like a growth stock with a sky-high, triple-digit P/E ratio because it continues to behave and invest like a growth company. Like other growth stocks, Amazon has traditionally operated near breakeven as it's invested in growth initiatives like new technologies and expanding its delivery network with new fulfillment centers.
By contrast, value investing tends to be viewed as the opposite approach to growth investing because value stocks are generally mature companies that trade at low P/E ratios. Investors buy value stocks because they believe they are undervalued by the market, not because they see enormous potential in them as they do with growth stocks. For instance, Warren Buffett's Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) conglomerate has been buying billions of dollars in Apple (Nasdaq: AAPL) shares as he believes the company has a strong brand and ecosystem of products, and that that along with its cash hoards and profits is being undervalued by the market. Buffett has traditionally been a proponent of value investing as he avoids riskier growth stocks that don't yet generate profits.
These are the four top qualities that every growth investor should possess:
1. Long-term focus
Growth investing is a long-term process. Unlike other stocks, a growth story can take a decade or more to fully play out. Value investors, meanwhile, attempt to take advantage discrepancies between the intrinsic value and market price of a stock, though many operate as buy-and-hold investors; dividend investors get paid every quarter, and options traders can make a quick hit, but growth investors often have to wait years for a payoff.
Because they have time to defer potential gains or wait for their investments to pay off, growth investors tend to have a long time horizon. Growth stocks can often be more volatile than investing in more mature companies, so the strategy works better for investors saving for distant needs such as retirement or a child's college fund. Investors like retirees, on the other hand, will have shorter time horizons as they will probably be planning on spending their savings in the coming years, or be using them as a direct income stream through dividends or by selling covered calls, a type of option that can generate income. In other words, retirees are more likely to be investing for income or wealth preservation and may want to steer their portfolios more toward value and dividend stocks. Investors of all types should consider a mix of growth and value stocks, but their time horizon will likely govern whether they weight their portfolio toward growth stocks, which can be riskier, or more reliable value stocks.
A long-term, buy-and-hold mindset also helps growth investors maximize their returns from their biggest winners. Thomas Rowe Price, the Founder of T. Rowe Price and the person considered the father of growth investing was known as an advocate for long-term investing. Holding growth stocks for the long term allows investors to benefit from compound interest, one of the most powerful forces in investing. Compound interest is the mathematical engine that makes gains grow on top of gains, or what makes your portfolio grow exponentially. In other words, if a stock doubled, and then doubled again, you would have gained four times your original investment. If it doubles two more times, you'd have 16 times what you originally put in. Investors of all kinds, including passive investors in index funds or mutual funds, can benefit from compound interest, however, growth stocks have the greatest potential to maximize the gains from holding over the long term due to their ability to generate high growth.
One example of a delayed payoff with a growth stock is Tesla (NASDAQ: TSLA), which traded sideways for its first few years as a publicly traded history as the company invested in manufacturing the Model S, its first sedan. In 2013, the stock soared is the company said it would begin selling the Model S, and said it would report its first quarterly profit. The stock gained 344% in that year alone and has doubled since then. Today, the company is engaged in a similar round of investments as it works to crank out the Model 3, its first mass-market vehicle, but the company is yet to make a profit. The risk/reward profile for Tesla remains high, but investors who stuck through from the early years have already been rewarded handsomely.
2. Risk tolerance
In addition to having a long-term mindset, growth investors also need to have a higher risk tolerance than the average investor. Growth stocks are riskier, meaning the range of potential returns is wider than with other stocks, and they're more volatile than the broader market. Therefore, they demand greater risk tolerance from investors, especially since such stocks should be held over a long period of time. Your risk tolerance is essentially the degree of risk you're comfortable with, and it is one of the most important things to determine about yourself as an individual investor. For example, a risk-averse investor might struggle with growth stocks as they would be more likely to sell after a bad quarter, thinking they would avoid further losses. However, by doing so they lose the opportunity for potential gains.
Personal disposition will have some effect on your risk tolerance. You may worry about losing your money in the stock market, or you may relish the chance to make big returns depending on your personality. It's also important for investors to be diversified, and keep emergency funds for unforeseen problems like a job loss or a health crisis. For growth investors especially, it's crucial to own multiple stocks as many of them won't pan out. The strategy counts on the winners outweighing the losers.
For other investors, the size of their portfolio may be the determining factor for your risk tolerance. If you're sitting on a small nest egg, you may be reluctant to invest it all in growth stocks, whereas, if you have more money to invest, you may feel comfortable putting some of your money in riskier growth vehicles. Finally, for many investors, your time horizon will guide your risk tolerance. When do you plan on using the money you're investing? If it's soon -- within the next few years -- you'll probably prefer safer investments. If you're young and have at least 10 or 20 years left before retirement, you'll be more likely to favor riskier stocks that can generate higher returns.
Tolerating risk and even embracing it is key to success as growth investors. The top growth investors understand that the winners will outweigh losers over time. Motley Fool Co-Founder David Gardner is a big proponent of this philosophy.
What follows is a real-world example. Netflix (NASDAQ:NFLX) shares are up 930% over the last five years while the S&P 500 has only gained 68% in that time. If you had invested $1,000 in Netflix and also invested $1,000 in seven other stocks that lost 50% of their value during that time, you still would have beaten the market. That's because the $1,000 you invested in Netflix would have turned into $10,300, while the $7,000 you invested in the others would have become $3,500 for a total of $13,800. From your original $8,000 investment, you're still up 72.5%.
Imagination may be the most important factor for growth investing. You have to be able to see a company evolving and growing over time, to visualize how markets will change, and how the company you're investing in will come to be a leader.
Again, Amazon offers an excellent example. The company was an early leader in e-commerce and has maintained that leadership since. Meanwhile, e-commerce grows every year, with online sales increasing by about 15% annually in the U.S., meaning Amazon's market is steadily getting bigger and should continue to do so as online shopping is only getting easier and more convenient. As a result, Amazon is now one of the country's biggest retailers. In its early life, Amazon was just a bookseller, but the company clearly had the potential to be much more, especially with the long-term focus of Founder and CEO Jeff Bezos.
The best growth investors are experts in recognizing industry disruption, and the companies with the potential to do so. They understand that optionality, or the ability for companies to grow in ways or areas that don't exist yet, can be the biggest driver of market-crushing returns in growth stocks. Some of the best growth stories have come from industry disruption and optionality. There's Amazon with cloud computing; Netflix with original content, and Tesla with the Gigafactory. Each one of those innovations taps into growth markets of their own that further feed investor dreams of market domination of an unknown future. Growth investors understand how to envision and explain the story of such growth and disruption as growth stocks are often driven by narratives, not valuations the way value stocks are.
It's important to note that growth investors don't have to find their own investing ideas, only to be able to imagine the potential of growth stocks that others have identified. There are no points for originality in investing, and you can make just as much money off someone else's investing thesis as you can from your own, though it's always important to do your own due diligence with someone else's recommendation. Also, the best growth stocks aren't necessarily companies you've never heard of. Often, the top ones are readily identified in the financial media as has been the case with the FANG group. Consisting of Facebook, Amazon, Netflix, and Alphabet (Google), those stocks have returned an average of 527% over the last five years. Apple and Microsoft, which are sometimes added to the group to make FAAMNG, have both nearly tripled in that time.
An important corollary to a long-term focus, patience is also key for growth investors. If you ask most growth investors what their biggest investing mistake was, chances are they won't tell you about a stinker they bought, or a stock they missed out on. They'll say they sold one of their growth stars too soon. For example, my colleague Rick Munnariz shared a story about sacrificing nearly $1 million in Netflix gains from selling most of his stake in the video streamer way too early. Other Fools have confessed to similar moves, and probably most growth investors can tell you about the one that got away.
Even billionaire investor Carl Icahn, who made $2 billion on Netflix after buying the stock near its nadir in 2012 sold it too early, missing out on more than $4 billion in gains.
Locking in gains by selling is a natural impulse that most investors have, and it can be crushing to watch big gains in a stock you believe in disappear over time. There's no ironclad rule about when to sell a stock, but events that change or undermine your investing thesis are good guidelines, such as a change in management or a shock to the brand. For instance, it's become clear that Apple is a very different company under Tim Cook than it was under Steve Jobs. Likewise, Chipotle may never return to its former greatness following the 2015 E. coli crisis. My colleague Brian Stoffel has a few more thoughts about when to sell.
While there are times when it's wise to sell, being a patient, long-term investor is the best way to reap huge returns in growth investing. All you have to do is to find disruptive companies with big growth potential, especially those that could benefit from optionality and put your money behind them for the long term. Not every pick will be a winner, and there will be plenty of losers. But thanks to the magic of compound interest and the upside potential of growth, you should find your way to some of the blowout returns that the best growth investors get.