Investors can use several strategies to make money in the stock market. One is to buy shares of growth stocks, which are the stocks of companies that are expected to increase their profits (or revenues) at faster-than-average rates. Companies that do so for extended periods can command higher share prices, enabling their shareholders to earn big returns.
Of course, investing in growth stocks is not a guaranteed way to make money in the stock market. Share prices of growth-oriented companies can be volatile since investors are constantly assessing their performances relative to high expectations. That's why it's wise to get familiar with the basics of growth investing before buying any shares.
What is a growth stock?
A growth stock is the stock of a company that's expected to increase its profits or revenues faster than the average business in its industry or the market broadly. Growth stocks appeal to many investors because Wall Street often values a company based on a multiple of its earnings (its profits), which may be diminished if the company is reinvesting most of its leftover cash in further expansion.
Growth-oriented companies tend to have savvy leadership teams focused on innovation, along with sizable market opportunities. They're often on the forefront of macro trends such as the rise of e-commerce and advances in financial technology. Amazon (NASDAQ:AMZN), for example, was a pioneer in the e-commerce space when it started selling books online in 1995. Alphabet (NASDAQ:GOOG) revolutionized digital advertising. And, more recently, Square (NYSE:SQ) brought digital payment services to small businesses.
How to evaluate growth stocks
Growth stocks also share some quantitative characteristics, including:
- Rising profit margins: The best growth stocks are those of companies with profit margins that are increasing over time. Profit margins that are negative but become positive while an investor holds the stock can result in significant share price increases, generating very high returns for the investor's portfolio. Other rapidly growing companies are already profitable and still increasing their profit margins; these companies are lower-risk investments and are usually more suitable for new growth stock investors.
- Strong sales growth: The best growth-oriented companies also significantly increase their revenues over time since the only reliable way to grow profits for years on end is to grow revenues, too.
- Projected growth of earnings: Analysts projecting that a company's earnings are likely to grow is a positive sign, and though analysts' projections aren't always accurate, they are useful for gauging market expectations.
- High returns on equity: ROE, or return on equity, is equal to net income as a percentage of shareholders' equity. A company with a high or rising ROE relative to its competitors uses capital more efficiently to generate profits.
- Manageable levels of debt: Since it's possible to achieve a high ROE by assuming high amounts of debt, it's important to also evaluate a company's liabilities. The company's ROE should not be overly influenced by its debt, and its debt levels should be comparable to those of competitors. The company's historic performance should show a trend of the company keeping its liabilities at manageable levels.
Where to look for growth stocks
The search for great growth stocks begins with identifying macro trends that change the way people do everyday things. Digitization, for example, has been a dominant trend over the past two decades. It's also paved the way for other megatrends such as the rise of e-commerce and streaming entertainment and the move toward cashless payments.
Once growth stock investors identify a trend -- say, the rollout of driverless cars or the shift to renewable energy -- that could be "the next big thing," they then identify which specific companies stand to benefit from the changing market dynamics associated with the trend.
Alternatively, investors can buy shares in growth-oriented exchange-traded funds (ETFs) and mutual funds. Prospective shareholders should first understand and agree with how a fund selects investments for its portfolio. But managed funds like these are a great option for investors who want to gain portfolio exposure to growth stocks without having to research and choose individual stocks themselves.
Examples of growth stocks
Growth stocks can be those of companies of all sizes. The growth stocks that confer the least risk and have the most history are those of large-cap companies, including:
- Amazon: The tech giant has grown its three-year annualized net income by 91% while increasing its annualized revenue by only 29%.
- PayPal: (NASDAQ:PYPL). The digital payments company has expanded its revenues by 17% and its net income by more than 32% annually over the past three years.
- Etsy: (NASDAQ:ETSY): The online crafts marketplace has increased its annualized revenue and net income over the past three years by more than 57%.
Mid-cap and small-cap companies can also grow at attractive rates, but they are more likely to couple strong revenue performance with inconsistent profitability. A few examples of companies like these are:
- IDEXX Laboratories (NASDAQ:IDXX): The maker of diagnostic products for pets has annually grown its net income by 30% and its revenue by 11% over the past three years.
- Pinterest (NYSE:PINS): The social media platform's three-year annualized revenue growth is nearly 53%, although the company is not yet profitable.
- Roku (NASDAQ:ROKU): The streaming device maker is also not yet profitable, but Roku has annually increased its revenue by 51% over the past three years.
Investors who want to invest in small-cap or mid-cap growth companies while minimizing their portfolio risk can gain the desired exposure by buying shares in diversified ETFs or mutual funds. The Vanguard Mid-Cap Growth ETF (NYSEMKT:VOT), for example, invests in 163 companies. The Vanguard Small-Cap Growth ETF (NYSEMKT:VBK) has an even broader range of holdings, with 613 stocks in its portfolio.
The risks of investing in growth stocks
While investing in growth stocks can be lucrative, their prices can be extremely volatile. A company's stock price tends to rise when the investment community believes the company will outperform its peers. This price increase can make the company seem overvalued, and, if the company's performance falls short of investor expectations, the share price is likely dip sharply.
Turbulent market conditions can be another source of price volatility for growth stocks, which are often more susceptible to wild price swings when market conditions are changing rapidly. Investors who are uncomfortable with large price fluctuations may want to reconsider pursuing a growth-oriented investing strategy.
Is growth investing right for you?
While the potential reward of growth investing is high, the risk is elevated, too. If you are willing to assume relatively high risk in exchange for the possibility of your investments' share prices appreciating significantly, then growth investing might be right for you.
Of course, pursuing a growth investing strategy is compatible with other approaches to investing. You can invest in growth-oriented companies along with value stocks that have more reliable outlooks. That's a smart way to control your risk while establishing a portfolio that performs well over time.