Growth investing is an investment strategy that focuses on businesses that have the greatest potential to grow explosively in both size and importance within their industries. The stocks that growth investors seek often look expensive or over-priced compared to the current revenue and earnings their businesses generate. However, investors are willing to pay more for these growth stocks because of the potential for life-changing returns for those who discover them early on. When growth stocks fail, on the other hand, they often fail spectacularly. Growth investing requires a willingness to accept heightened levels of risk in the hopes of capturing extraordinary returns.
The 7 traits of great growth stocks
It's important for growth investors to identify the stocks that have the best chance of becoming tomorrow's blockbusters. But how can you separate the best from the rest? Historically, companies with the following traits have a much better chance of becoming great growth stocks than companies that lack them:
- A large and expanding market opportunity
- A durable competitive advantage
- Financial resilience
- Repeat-purchase business model
- Strong past price appreciation
- Great corporate culture
- Talented leadership with skin in the game
Let's expand a bit more on each of these principles to see why they work.
1. A large and expanding market opportunity
The most successful growth stocks have produced revenue growth of 10% per year or more over extended periods of time. That's nearly impossible to pull off unless the company goes after a massive market opportunity.
A growth company often starts out by becoming a leader in a specific niche of a promising industry and then expanding into adjacent markets to broaden its addressable market. Over time, those new markets let the company continue to grow revenue even as it gets bigger, extending its runway for future growth over the long term. Think Amazon.com (NASDAQ:AMZN), which started out focusing on book sales and then expanded to disrupt the entire retail business model.
2. A durable competitive advantage
Legendary investor Warren Buffett looks for businesses with a durable competitive advantage. If a company can maintain its competitive advantage over its rivals for an extended period, it can protect its profits and sustain its growth.
You can find four key types of competitive advantages.
- Network effects apply when a business becomes more valuable when it has more customers, such as with an online marketplace.
- High switching costs can dissuade existing customers from moving to a rival service provider, leading to greater retention.
- Low-cost producers such as Costco Wholesale (NASDAQ:COST) can charge less for their goods and services while still making a profit, giving them flexibility in pricing that higher-cost rivals lack.
- Intangible assets like brand awareness or intellectual property often gain an insurmountable advantage through business reputation or quality that rival products lack.
3. Financial resilience
Growth companies that can fund their future growth needs with internally generated cash flows don't have to worry about the health of the financial markets. That's not to say that growth companies have to be profitable from the moment they start operating. Early on, most growth companies invest any available money back into their businesses to accelerate their growth, and that can create short-term losses. Eventually, though, companies that regularly operate at a loss will have to get new capital from investors, and that often hurts returns for those who invested earlier.
4. Repeat-purchase business model
Attracting new customers to a business is difficult and expensive. It's far better for a business to make money by selling products or services to existing customers instead of relying on an endless stream of new customers to drive growth. Many top growth companies emphasize bringing in subscribers who will keep paying for a service indefinitely or selling products that get consumed quickly and then require customers to buy more on a regular basis.
One example is Starbucks (NASDAQ:SBUX), which has thrived even through tough economic periods by counting on customers coming in every day for hot beverages. By contrast, makers of longer-lasting consumer products like camera specialist GoPro (NASDAQ:GPRO) have, in a way, been victims of their own success. GoPro's products are durable enough that they don't require repeat purchases and therefore have limited prospects for revenue growth.
5. Strong past price appreciation
Winning high-growth companies tend to keep on winning. A stock typically beats the market because its business is humming along, and Wall Street rewards that success by giving it a higher share price. That's certainly been the case for electric vehicle pioneer Tesla (NASDAQ:TSLA), which has had huge upward stock price momentum over time. Those who wait for top growth stocks to look cheap by measures like price-to-earnings ratios or market capitalization often find they never get a good chance to buy in -- even as the stock price continues to go up and up.
6. A great corporate culture
Growth companies need to bring on an endless stream of talented employees over time to enable them to meet the demands of their customers. Top companies prioritize retaining key employees while also attracting high-caliber new ones.
Having a great company culture in place is critically important. The best indicator of strong culture is a satisfied employee base, and review sites like Glassdoor can tell you whether workers approve of the CEO, recommend their employer, and have positive views of how the company does business.
7. Talented leadership with skin in the game
Last, great growth stocks have corporate leaders who are deeply committed to the company's mission and have incentives to make the business a success. Having a founder at the helm is often a good indicator. It's certainly been a key contributor to long-term share-price gains for companies like Jeff Bezos' Amazon, Mark Zuckerberg at Facebook (NASDAQ:FB), and Reed Hastings at Netflix (NASDAQ:NFLX).
In addition, looking at whether these leaders own considerable amounts of stock is a valuable indicator of confidence in a company. If a CEO or founder truly believes the company will thrive, then having a big portion of their personal wealth in company shares is the best way to maximize profits. If leaders sell off substantial portions of the stock they own, it's a sign of a lack of confidence.
Investing in growth stocks
Growth investors have to be willing to take on risk, but the rewards can be great. Many mutual fund investors use growth funds as investment vehicles to get exposure to good growth stocks. Whether you choose to invest in a growth-focused index fund or take the time to individually find stocks with high-growth potential, growth investing can help you reach your long-term financial goals.
If growth investing feels too risky for you, consider the value investing approach. Value investing looks more at whether a stock is attractively valued than at its future growth prospects, seeking to find out-of-favor companies that have had their share prices unfairly beaten down.
Read More: Growth vs. Value Investing