Every investor wants growth. After all, growing profits are what leads to rising stock prices. If a company can't grow, there's little reason to expect its share price to increase. It's no surprise then that growth investing is one of the most popular forms of investing today. The strategy gives investors the best chance of maximizing returns as they hunt for stocks that could return many times their original investment. Over the last decade, while the market has boomed, many growth stocks have generated returns of 1,000% or more, making some investors rich in the process.
In this comprehensive look at growth investing, we'll explore the history of this investing strategy, consider some of the benefits and risks, look at some popular growth stocks and assess whether growth investing is right for you.
What is growth investing?
Growth investing focuses on capital appreciation above all else. Unlike other strategies like value investing or dividend investing, which have a reputation for centering on income or wealth preservation, the growth investor's greatest goal is to increase the value of their portfolio.
According to the principles of growth investing, the best way to do so is by putting your money in stocks that are expected to grow their sales and profits many times above current levels. Even though such stocks may already be expensive according to traditional metrics like the price-to-earnings ratio or price-to-book ratio, growth investors believe that the future earnings of such companies will justify the price tags and then some.
The origin and history of growth investing
Thomas Rowe Price, who founded the investment firm T. Rowe Price in 1937, is considered the father of growth investing and was the first person to describe and use the term growth stock. The early part of his career came during the Great Depression, the worst financial crash of the 20th century that wiped out nearly 90% of the Dow Jones Industrial Average. As a contrarian thinker, however, Price saw opportunity in the crash to invest in good companies, viewing the catastrophe as part of the economic cycle.
The characteristics Price looked for in stocks included a lack of cutthroat competition, protection from government regulation, and at least a 10% return on invested capital, high-profit margins, and superior earnings-per-share growth. In 1950, he started his first growth stock fund, which returned nearly 400% over the next decade. Presciently, in the early 1970's Price began to think that growth stocks had become overheated and sold off much of his stake in his firm. That move was followed by a collapse in growth stocks as the market crashed.
Another key figure in the origin of growth investing is Phil Fisher, the author of Common Stocks and Uncommon Profits, which was published in 1958 and advocated for long-term investing and buying stocks with a significant potential to increase sales. Fisher preferred innovation- and technology-focused stocks, investing in companies that spent much of their capital on research and development, and, like Price, invested for the long term. He also targeted stocks with a growth orientation, high profit margins, high return on invested capital, a leading position in its industry, and well-branded or proprietary products and services.
In recent years, growth investing has become synonymous with tech stocks as the advent of the internet unleashed a huge growth market in tech. While many companies did not survive the dot-com bubble, today we've seen a resurgence in tech growth stocks in areas like cloud computing, e-commerce, and artificial intelligence, and such stocks have driven the bull market. In fact, the four most valuable U.S stocks today are all tech companies: Apple, Alphabet, Amazon (NASDAQ:AMZN), and Microsoft.
Growth investing vs. value investing
Though there are a wide variety of investing strategies, growth investing and value investing are generally seen as the two "poles" of the money management world. While growth investors focus on finding stocks with high growth rates, value investors tend to gravitate toward stocks they believe to be undervalued. These tend to be more mature companies with stable incomes that have a low valuation in a measurement like price-to-earnings or price-to-book, and value investors buy when they believe the intrinsic value is worth more than the market price of the stock. Value investors try to determine the intrinsic value of a company through valuation methods like discounted cash flow analysis, which derives a company's net present value based on its future cash flows.
While value investors tend to focus on more quantitative factors, growth investors are likely to look at qualitative characteristics. Growth stocks are also sometimes called story stocks because investors are focused on the narrative behind the company and its growth rather than hard numbers. Some key concepts growth investors look at that help define the growth story are industry disruption, optionality, economic moat, leadership, and total addressable market. Using such guidelines helps find high-growth stocks as the "story" driving their future success can't be found in the numbers.
Growth investors also tend to focus on the long-term as growth stories can take a while to play out. Value investors, on the other hand, can sometimes succeed by recognizing short-term discrepancies between the intrinsic and market values of a stock. Once those two values realign, they believe it's best to redeploy that capital to other undervalued stocks. Therefore, growth investors generally have a longer time horizon than value investors.
Over the years, a number of different growth investing strategies have evolved from the early thinking of Price and Fisher. Growth investors today focus primarily on stocks with the following characteristics.
Long-term growth comes from the ability to break current industry dynamics with new technology or some kind of competitive advantage. For instance, Netflix (NASDAQ:NFLX) has disrupted the video entertainment industry twice. First, with its DVD-by-mail model and now with video streaming, which caused cable subscriptions to decline. Meanwhile, Netflix is as strong as ever with revenue increasing more than 40% in its most recent quarter.
This may be the most important concept to understand in growth investing. Often, the business line or factor that will help drive a company's future growth doesn't exist yet. The ability for a company to make that happen is known as optionality, and it's much more common in growth companies than mature ones. Amazon, for instance, is constantly experimenting with new businesses, products, and services. It doesn't always pay off, but when it does it can have a huge impact, as we've seen with the growth of its cloud computing division, Amazon Web Service. Ten years ago, investors had no idea that AWS would one day generate billions of profits. There was no way to predict that, but the company's culture of experimentation and invention made it possible.
Total addressable market
The easiest way to understand how big a company or a product could potentially become is to look at the total addressable market or the number of potential customers and, therefore, sales. For instance, in the early days of the iPhone, investors were salivating over the opportunity for Apple as the total addressable market for smartphones showed that annual unit sales could one day be more than 1 billion. That difference, between the total addressable market and what the company has already accessed, separates growth companies from mature ones.
Finally, leadership is a key factor in successful growth companies as the business leader makes the decisions that often determine a company's future. Growth companies tend to be founder-led as they are often built on new ideas or products, and visionary CEO's have the ability to guide such companies to huge growth and returns. The three companies above, Apple, Netflix, and Amazon, all exemplify the importance of a visionary founder.
Risks of growth investing
While investing early in the right stocks can pay off with huge returns, investing in growth stocks comes with certain risks. Growth investments in any asset class can become a victim of "irrational exuberance," a term given in the 1990's by then-Federal Reserve Chairman Alan Greenspan to the boom in tech stocks. Greenspan believed that unwarranted hype was driving the price of dot-com companies, and indeed he was proven right in 2000 when tech stocks started to crash, and many dot-coms went bankrupt. We also saw this pattern repeat with home prices in the 2000's and cryptocurrencies over the last several months. Such booms are often driven by speculation, or investors' buying an asset only because momentum has been driving its value higher. Such speculative momentum, which is divorced from the fundamentals of the asset, builds to a peak and usually ends in a crash.
The biggest risk then with growth stocks is that since their prices are often disconnected from fundamental values like earnings or book value, and premised on fuzzy concepts like future growth, the stock can quickly fall if investor sentiment changes. Since growth stocks, particularly the "FANG" group of stocks, have surged in recent years, those high-priced stocks could be primed for a pullback if the economy slows or the broader stock market starts to fall.
Some popular growth stocks
The chart below shows some top growth stocks with key performance and valuation figures.
|Company||IPO Year||Growth since IPO||Market cap||P/E ratio||Revenue growth (mrq)|
As you can see, all four of these stocks have skyrocketed during their time as publicly traded companies despite trading at sky-high valuations. Shopify and Tesla aren't even profitable, which is why they don't have P/E ratios, however, that hasn't stopped investors from piling into these stocks. That's because all four of these companies have something unique that gives them huge growth potential.
Amazon needs little introduction at this point. The company has come to dominate e-commerce and continues to push the envelope with its acquisition of Whole Foods, drone delivery tests, health insurance pilot, and the cashier-less Amazon Go store. It's also the leader in cloud computing and is pioneering businesses like voice-activated technology and video streaming. Amazon has delivered blockbuster returns thanks to optionality and the network of competitive advantages stemming from its Prime loyalty program. Its sky-high valuation seems warranted as the company is poised to dominate the future in a broad swath of industries.
Netflix has pivoted from a DVD-by-mail service to a video streamer to the biggest producer of original entertainment, disrupting business models including the video store, cable TV, and Hollywood along the way. With phrases like "Netflix and chill" in the lexicon, Netflix has reached a point of cultural relevance and mindshare that few other companies have. Much like Google is synonymous with internet search so is Netflix a stand-in for video streaming. Revenue and subscriber growth have accelerated recently in spite of a price hike, showing the company's pricing power and consumer appeal. The addressable market internationally remains substantial and there's reason to think the service could eventually be in nearly every household in the U.S.
Shopify is significantly smaller than the other companies on this list, but the company is still chasing a huge opportunity. The Canadian firm is the leader in e-commerce management software for small and medium-sized business selling their wares online. The company provides services such as payments, sales management, marketing, web design, and more. As a subscription service, Shopify benefits from high switching costs as businesses are essentially locked in once they get their store up and running with Shopify -- it's a huge headache to switch providers. With e-commerce sales growing steadily in the U.S. by around 15% annually, yet making up less than 10% of total a retail sales, there should be a long tail of growth ahead for the software company.
Arguably, no company has excited investors the way Tesla has in recent years. The company is pushing the boundaries in a wide range of technologies including electric vehicles, autonomous vehicles, lithium-ion battery cells, solar power, its Supercharger vehicle charging network, and the Powerwall, its renewable home energy unit. While legitimate concerns have arisen about Tesla's cash flow and production challenges, the company's ambitions in automobiles and renewable energy have earned it a market cap in the range of traditional car-makers like General Motors and Ford even though Tesla has only a fraction of their production capacity. For now, investors still believe in the story and the long-term potential of Tesla and CEO Elon Musk.
Is growth investing right for you?
With its potential to generate blockbuster returns, it's a good idea for almost any investor to have a few growth stocks in their portfolio. The strategy will naturally appeal more to risk-tolerant investors and those with a longer time horizon as it can take time for growth stocks to generate sizable returns, and some will fizzle out, making it riskier than buying value stocks or dividend stocks.
For long-term investors, growth-investing is a good choice as it only takes one big winner to drive superior returns in your portfolio. For income-focused investors and retirees concerned with wealth preservation, diversifying with a few growth stocks can be a wise decision as well.
The bull market over the last nine years has been driven largely by growth stocks, and that's likely to be true of future market rallies. The ups and downs of growth stocks can be hard to stomach at times, but for long-term investors, history has shown that growth investing usually pays off in the end.
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Jeremy Bowman owns shares of Apple, General Motors, and Netflix. The Motley Fool owns shares of and recommends Amazon, Apple, Netflix, Shopify, and Tesla. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool recommends Ford. The Motley Fool has a disclosure policy.