Growth Stocks – A Comprehensive Guide to Success

An infographic explaining what growth stocks are, its characteristics, how and where to find growth stocks, its benefits, and how to reduce the risk when investing in growth stocks.

Since the opening of the New York Stock Exchange (NYSE), investors have made a lot of money in the stock market. Since then, it has been every investor’s dream to find that one top stock that will make them rich. A stock from a fast-growing company that is expected to outpace other companies in their sector in revenue and earnings multiple times over, could very well be that top stock. 

Growth stocks are not for everyone because the potential of high returns comes with high risk. Investors buy these stocks not to provide a steady supply of income but instead to generate capital gains for them. Investors who invest in growth stocks should be in it for the long haul and able to withstand the inevitable ups and downs of the market.

This article explains what growth stocks are, their characteristics, examples of growth stocks, and where to find them. In addition, it shows you the pros and cons, and how to reduce risk when investing in them. 

What Are Growth Stocks?

Growth stocks are shares in a company that is anticipated to grow its revenue and earnings at a rate significantly above the average growth of a company in the same industry. Companies’ shares are usually valued as a multiple of their earnings (earnings per share). An increase in earnings usually results in the price of the stock going up. Therefore, companies that can increase their EPS consistently for a period of time will see their share price reach a new high. As a result, growth investors will see big returns through capital appreciation.

The majority of growth companies do not share their profits with shareholders in the form of dividends. Instead, they opt to reinvest their earnings into their business. As a result, they can keep expanding and grow their earnings faster than other similar companies. Even some companies that are not yet profitable but are experiencing enormous revenue growth can be considered growth stocks.

Dividend stocks are the opposite of growth stocks.  They are shares in usually well-known, established companies with a track record of distributing dividends to their shareholders. Dividend stocks distribute a portion of the company’s earnings regularly. Most U.S. dividend stocks pay investors dividends quarterly. Some companies increase their dividends over time. Of course, this is very attractive to older investors looking for their investments to provide a steady income supply. Examples of dividend stocks are Johnson & Johnson and Coca-Cola.

Growth stocks can be found in different sectors, industries and are traded on different stock exchanges. Many companies that produce growth stocks are growing exponentially or introducing new technologies and innovative products for which they have patents. 

Tech stocks are a good example, as they typically put all their earnings back into their businesses. They often reinvest the money in Research and Development. Then, when these companies introduce a new product, they will price this product at a premium. If the product is successful, competitors want to imitate it, but they won’t be able to because the tech company will have a patent on it. Sales will increase, earnings will go up, and the price of this growth stock will go up as well. Growth companies are often looking for the next big thing. Facebook and Amazon are good examples of growth stocks.

Growth stocks are generally riskier than other types of stocks, but they also offer higher potential returns.  They generally overperform in a good economy when stock prices are going up. However, they tend to underperform the market when stock prices go down.

Characteristics of Growth Stocks

The key to success is selecting the right stocks. There is no exact definition as to what makes a growth company successful. However, sometimes it is believed that the company should have at least a three-year earnings growth rate of 15% or higher while being in an industry that has a 10% earnings growth over the same 3 years. Besides this, growth stocks might have some other common characteristics:

  • Faster than average growth – Growth companies are mostly known because of their increase in revenue and earningsat rates much higher than the average company in the same industry. Also, investors expect that the company’s rapid growth will continue in the future.
  • A growing market and a large market share – To grow and keep growing, the market the company operates in must be showing significant current and future growth. If a market is reaching a plateau, there will be less chance for the growth stock to keep performing well. Also, the company should have a significant market share in the growing market. An example is Alphabet’s Google (NASDAQ: GOOG). Google is the world’s dominant search engine, and together with Facebook, it rules the digital advertising market.
  • Strong leadership – Fast-growing companies often have strong innovative leadership to keep the company ahead of the competition. Investors should research the leadership team and make sure they have a good track record. It is also a good sign when top management owns a large number of stocks in the company. This shows that they have confidence that the company is going to do very well.
  • A high past price and rising stock price – Because the stock price is already high, investors are willing to pay a premium price for the shares as they expect additional growth in the upcoming years. A good example is Tesla (NASDAQ: TSLA). Its stock has had huge price increases in the past, but the price keeps going up because of consumer confidence. Investors that think they have found a good growth stock should act on it. Waiting until the stock price goes down is usually not a good strategy, as it will often result in losing out on significant returns.
  • Consistent competitive advantage or niche market – Companies that are great at one thing and distinguish themselves from the pack can return high profits year after year. Facebook is still the leader in social media. In fact, it is expanding in different areas such as online dating and retail sales, which will ensure its future growth. Competitive advantages such as brand awareness and intellectual property can keep rivals at bay and sustained growth a reality.
  • No dividends Most of the growth companies decide to reinvest their profits back into their business to increase their growth rate. There are numerous ways in which a company can reinvest their earnings. For example, they can spend more money on research and development or re-build their commercial infrastructure to attract more customers.

Please remember these are just common growth companies’ traits and do not have to be held true for every company. 

Where to Find Growth Stocks?

If you look at a list of the best growth stocks and companies from recent years, you will notice that most did not exist a few decades ago. They have grown consistently at such a high rate that now they are the market leaders in their respective fields. Some examples are Amazon.com (NASDAQ: AMZN), Netflix (NASDAQ: NFLX), and Ulta Beauty (NASDAQ: ULTA).  All of them achieved huge revenue and profit growth, resulting in significant stock price increases year after year. 

So, how you can find the next Amazon.com or Netflix while they are in their early growth phase? One way is to look around for companies in your environment that promote new habits, innovative products, or even new ways of doing things. Some of those products or services might be from companies growing faster than other companies in their sector. If this growth has been significant, consistent, and shows future potential, and if you believe these products are keepers, then the stock might be worth looking at.

Think about changes in eating habits, for example. Flavored water has become increasingly popular, and so have healthier fast food options like Chipotle. Changes in entertainment preferences such as streaming services like Netflix and Hulu are also hot. New e-commerce companies, such as Wayfair, have taken off because they make life easier for all of us.

Surfing the net can also help in identifying growth companies. Zoom Video Communications (NASDAQ: ZM) makes teleconferencing and distance learning a breeze. Fiverr (NASDAQ: FVRR), an online marketplace for freelance services, is a very popular site and offers services from content writing to graphic design to programming.

Also, consider major changes in society that are currently happening. Think about the aging of the population that is going on. This will inevitably increase the demand for senior living facilities and healthcare services catering to that group. Another societal trend that has gained popularity is health and wellness, reflected in increased healthier food options and athletic apparel clothing such as Lululemon Athletica (NASDAQ: LULU).

Finally, stock screening tools can help identify growth stocks as well. A stock screener can help you focus on the stocks that meet your standards and investment goals. To find growth stocks, you will have to set your standards accordingly. Some stock screeners that might help achieve that are:

  • The most important screen is for price appreciation. It should show you stocks with prices that have risen at least 15% or more during the previous month and eliminate stocks such as penny stocks and stocks that are under $10. Low priced stocks are just too volatile.
  • Screen for a price to earnings ratio (P/E ratio) that is at least positive or a specific positive number. This will weed out companies that have had negative or no earnings yet.
  • Screen for a low debt-to-equity ratio. The lower the number, the better, as debt eventually will have to be paid back.
  • Screen for certain sectors. Analyze which sectors have had the most successful growth stocks recently and screen for companies in those sectors. Technology, healthcare, finance, and e-commerce have been top performers when it comes to growth stocks.
  • Screen for cash flow. Sustainable positive cash flow is key to a company’s financial growth prospects. Good financial health usually leads to an increase in the share price.

Examples of Growth Stocks

Investing in growth stocks can be risky. Especially when you consider they have a high price tag and usually do not pay dividends. Why take this risk? The answer is easy; some growth stocks have made some investors incredibly wealthy. Here is a list of some growth stocks that have generated huge returns for their investors. 

Table that shows 10 growth companies that have had large returns over the last 3 years. The two companies with the highest returns are Tesla and Lululemon that each had returns of over 80% in the last 3 years.

Risks of Investing in Growth Stocks

No doubt investing in growth stocks can bring high returns. However, it is also known that only a small percentage of growth stocks will turn out to be the “next best thing.” So, what exactly makes investing in growth stocks a risky endeavor?

The high valuation of the stock is the main risk. High valuations reflect high expectations for the company. If those expectations are not met for whatever reason, investors lose confidence in the company and sell their stocks. Consequently, this will result in a sharp decline in stock price. 

Other factors that might negatively affect a growth stock are failed product launches, lack of management experience, and a lack of innovative technologies.

Another risk that investors need to pay attention to is that although growth stocks do well in a bull market because market sentiment is up, they do worse than most other stocks in a bear market, as investors will be less likely to take on risk in a slowing economy. 

How to Reduce Risk When Investing in Growth Stocks

As mentioned previously, growth investing can be a risky business. There are, however, some things that can be done to reduce those risks. 

First and foremost is diversification. Investors can protect themselves by investing in many different growth companies in different sectors. This way, if some of them do not make it, hopefully, others will be successful and not all is lost. Furthermore, the portfolio might even make money despite the losses. Also, to spread the risk even further, only a certain percentage of securities in a portfolio should be growth stocks. A portfolio should also hold value stocks, bonds, and maybe even international stocks. The percentage of growth stocks in a portfolio goes up with the increase in risk an investor is willing to take. 

Investors can also reduce risk by not investing in companies that are losing money and that do not make any profit. Many investors will only invest in a company when its stock price has decreased because they believe they are getting a good deal. However, for growth stocks, a high-valued stock means that the company is already doing something that causes the market to pay attention. Investing in those stocks will make the price go up even further.

How to Invest in Growth Stocks?

Most investors will only invest a portion of their portfolio in growth companies. For the average retail investor deciding which stocks will be successful is very difficult. A good option for those investors would be to buy a mutual fund that specializes in growth funds. This way, the investor will end up with a basket of growth stocks that meet the criteria of growth investing and is managed by a professional financial advisor. 

There will be different growth funds to select from, and investors have to make sure to select the ones that meet their investment goals. A growth and income fund will most likely also hold dividend stocks, so this will be a more conservative fund. An aggressive growth fund will most likely hold stocks from either struggling or new companies with good prospects but no proven track record, so this type of fund will be a high-risk fund.

The other way investors can add growth companies to their portfolios is by choosing the stocks themselves. In that case, paying attention to what is going on in the market and current events is critical. Investors must consider their risk tolerance and investment objectives before deciding to invest in growth companies.

Who should be a Growth Investor?

Growth stocks are not for everyone because the potential of high returns comes with high risk. Investing in growth stocks is most suitable for investors with a long-term time horizon, so they have the time to recover if the stock price goes down. Growth Investors buy growth stocks to generate capital gains, not to provide a steady supply of income.

Generally, this is not the right strategy for retirees or people close to retirement age since they rely on that steady income stream. Growth stocks are volatile, and when there is a downturn in the market, retirees might not be able to wait for the market to recover. 

Only investors that can withstand the inevitable ups and downs of the market should be growth investors. It is not uncommon for a successful growth stock to decline by 75% or more for a few years and skyrockets again to new extreme highs. Because of the volatility, investors need to be financially secure to hold on to the stock when the price is very low.

Growth investing, when done the right way, can be a very lucrative investment strategy. Investors need to educate themselves on finding the right growth stocks, and they have to be aware of the risks involved and the patience required. Only then should an investor take the plunge and invest part of their portfolio in growth stocks to generate wealth.

Vikram R
Vikram Raghavan is a value investor, technologist, and Finexy co-founder. In addition to stock market investing, Vik also invests and advises startups on growth marketing and product management. Vik's work is focused on themes of marketplaces, micro-entrepreneurship, marketing automation, and user growth. Previously, Vikram led product and growth teams at Overstock.com, focusing on efforts across acquisition, new user experience, churn, and notifications/email. He holds an MBA in Finance from Temple University and a B.S. in Computer Information Systems and Finance from Bemidji State University.