Growth stocks tend to be riskier than other stocks. As the saying goes, "You won't grow without taking risks." The wise long-term investor needs to understand this and also needs to have a firm understanding of warning signs to watch for that a risk is too great.
While there are thousands of things that could potentially go wrong with a growth investment, there are three signs to be particularly alert for.
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1. An unproven business model or core technology
The first warning sign to beware of with growth stocks also happened to be the most insidious. Be on the watch for an unproven business model or an unvetted core technology the business model rests on.
Nano-X Imaging (NNOX -7.44%) provides an example here. Its entire business relies on its innovative X-ray source, which enables significantly cheaper X-ray scans. If that potential benefit is proven to be real, it's doubtlessly a competitive advantage that could be a major point in the company's favor (and eventually the stock's favor as well). But one controversy it's faced over the last few years was that there wasn't any third-party confirmation that its secretive, proprietary X-ray source actually worked for doing any kind of X-ray imaging at all.
Eventually, Nano-X demonstrated the technology to investors in a way that validated a few of management's claims, and it recently got approval from the Food and Drug Administration (FDA) to market its product. So one of the warning signs is definitively resolved without incident, though it's clear that the company's stock would've taken a severe beating if regulators had confirmed investors' skepticism by rejecting its FDA application.
Nano-X is also opting to use an untested business model in which its corporate customers pay a smaller amount for the device, but then they need to pay Nano-X a fee for every X-ray scan made with the company's devices. Typically, hospitals make a major capital investment to buy the machines and then keep all the fees charged to patients when the device is used. Nano-X's approach is quite different, which is a major risk until proven to work.
As an investor, you don't need to feel obligated to accept those kinds of major risks, and in most cases, you shouldn't take on those risks. Any new technology or new business model that's going to hit it big needs to be proven or validated in at least some basic and public way before shareholders benefit. Or such a play ends up flopping despite promises made that couldn't be kept. For what it's worth, Nano-X has kept its promises so far. But if you notice there are a few gaps in a stock's story, you don't need to take a leap of faith -- just wait for the evidence before moving forward.
2. Absurdly high valuations
Perhaps the most common warning sign you'll encounter with growth stocks is an inflated valuation that doesn't make sense.
Valuations get inflated when market traders bid up shares in anticipation of significant future growth in revenue or earnings that have yet to happen. You're probably familiar with basic valuation metrics like the price-to-sales (P/S) ratio and the price-to-earnings (P/E) ratio. These metrics offer basic clues about whether a stock is over (or under) valued. They are easy to understand and provide a quick comparison point to other similar stocks.
Just because a company has a high valuation doesn't mean it will let down people's expectations for growth. It's entirely possible for a company's valuation to be extremely high, and for that company to then go on to deliver massive returns for its investors. For example, Costco Wholesale's (COST 0.77%) stock is notoriously expensive, yet its consistent expansion over the course of years has largely led investors to accept that the high valuation is justified.
At the same time, when valuations start to balloon, it's also a sign that there might be a hype train picking up steam. And when hype gets rolling, sometimes it gets so far ahead of what a business could actually feasibly accomplish that it becomes unsustainably unrealistic. At that point, all it takes is one disappointing quarterly report or some bit of breaking news to puncture the hype balloon and quickly shrink the stock price.
So be sure to do regular sanity checks on any potential growth stock's valuations you are considering before taking the plunge. That goes double for situations in which the company isn't consistently profitable. Without profits, a business will have a very hard time ever returning much capital to investors -- or even sustaining itself in the long term.
3. Repeatedly bulking up on debt
Most growth-phase companies need to take out some debt as they ramp up operations. It can be used to buy time and allow it to grab market share before a competitor does, to become more efficient and reach profitability, or to work on research and development (R&D) projects. Having some debt is fine. The warning sign is when the borrowing is constant, because that tends to create situations where paying the debt back gets tricky.
There are a few reasons why taking out multiple loans per year is a risky business practice. First, each new dollar of debt means that it's a bit harder to borrow in the future at a low interest rate. Especially for unprofitable businesses, that's not an idle concern, as (obviously) the money will eventually need to be paid back, which requires making a significantly larger return on the borrowed sum than the cost of interest. Second, especially in today's inflation environment, it's possible that the Federal Reserve will increase the cost of borrowing money by hiking the Federal Funds rate. So variable-interest-rate debt may get more expensive to service, and quite quickly.
Finally -- and this is the most important factor -- every dollar spent on paying off interest is a dollar that the company doesn't have to invest in growth. That might not seem like a major concern for small amounts of borrowing, because it isn't. But once a business' debt-to-equity ratio starts to tick upwards toward 100, there's going to be less and less cash available to deploy for the benefit of investors in the future, and that can ruin your returns.
