There are several investing strategies employed by investors, but one that seems to attract the most interest is growth investing. Finding stocks that will produce high returns in a short period of time.
As you may expect, finding businesses that will increase profits faster than the average rate can be difficult, finding businesses that can do this for extended periods of time is even harder. These are the companies that will return massive capital appreciation.
Keep in mind… With the potential for high growth, comes higher risk. It is essential that you learn how to manage your risk, to protect your money.
What is a Growth Stock?
A growth stock is a company that is expected to increase revenue/profits much quicker than the average business in the same sector or industry.
Growth stocks appeal to many investors because Wall Street generally values a company based on a multiple of its earnings. Meaning, if a company can grow its earnings rapidly, the share price can increase massively in a short period of time.
There are more common aspects of a business that can make it liable for high growth, these traits include, large market opportunity, a solid business model, or a new viral product.
Examples of some recent growth stocks are:
- Alphabet (Google)
If you look at a list of high growth stocks, you might notice that the companies didn’t exist 20 years ago, but now are household names. Over the last 20 or so years, the majority of high return growth stocks have come from the tech industry, the advances in products and the high public demand have made the businesses very desirable among investors.
Where can you Find Growth Stocks?
Just like any other stock market investment you should stick to companies found on the major exchanges. For example, Amazon, Netflix & Alphabet are available on the NASDAQ, whereas Chipotle and Mastercard are found on the NYSE.
The trouble is, when these companies are at their most desirable, they are tiny businesses that no one is looking for.
The best place to find growth stocks is in your imagination… Sounds weird right? But think about this. 5 Years ago, what was a major problem you faced? If you’re like me, I needed a safe way to purchase things online without giving my bank information… Incomes PayPal!
I wish, when I needed that online service I didn’t say… “I bet a lot of people have this problem”. Because if I had predicted that PayPal would have 350 million users in 2020, it would have been my first purchase that next morning.
The price I would have bought PayPal at 5 years ago would have been $34.69… The price on August 31st 2020 was $204.48… I would have gained a massive 489.45% just by figuring out what people need!
What you Need to Look Out For
As I already mentioned, we are looking for companies that have a strong growth in sales, normally that beats the growth of the overall market or industry.
However I no longer believe this to be the biggest factor when choosing growth stocks. I would be looking more towards developments in different industries that lead to big changes. For example, Tesla’s revolutionary electric car has caused a fundamental change in the way businesses in that industry operate.
Ten years ago, Tesla was in massive debt, with near to zero revenue, investors did not look at Tesla as a sensible investment. But with the strong leadership of Elon Musk, and the intelligent technology they developed, Tesla is now one of the fastest growing companies on the NASDAQ.
So my final thought on what you need be on the look out for is… New ideas/products that will potentially change the industry. (This is why I recommend investing in businesses you understand).
The Best Growth Stocks Follow These Rules
Alongside being a business that can potentially change the world… Without following these five rules, they could be a huge flop.
- Good Financial Fundamentals: I know we just said Tesla was in massive debt ten years ago, but they are 1 in a million. Basic growth in revenue and solid debt to equity ratios is a good place to start with growth companies. The small company needs excess cash to be able to grow.
- Trend-Setter: Fidget-spinners, Tamagotchis, and Mobile phones… Which trend is still going? Mobile phone companies have been the centre of the biggest trend since the 80s, and as my dad will say – “I thought mobiles wouldn’t last past the 90s”! Find companies with new trend ideas that you believe will stand the test of time.
- In a Valuable Industry: Unfortunately, not many companies in the utilities or industrials niche are going to produce huge growth. You might get lucky, but I would stick to more mainstream industries where changes are happening all the time, such as tech, energy, or medicine.
- A Strong Brand & Advertising Strategy: Brands like Coca-Cola, Microsoft and Pfizer come to mind… These are companies that everyone knows. Don’t get me wrong, other companies sell soda, or computers, but these guys are the best… Because they have the strongest brand and advertising strategies. Companies that engage with the public more, will demand a higher target audience, hence increasing market share.
- Strong Management Team: Companies require a lot of organisation to grow. Because the companies we are looking for are focused on increasing profit and sales, the management team matters a lot. Innovative leaders with ambition are needed to fuel the growth we want. Without them, it won’t happen. You can research a companies management team through the investor relations section of their website.
From these rules, a couple stand above the rest. Management, Brand, and industry in my opinion are the cornerstones to great businesses. The more risk averse people will focus more on financial security, but as Tesla proved… It’s not always about money in the early days.
Fundamentals Explained… What We Want to See
Diving into the fundamentals of a company can reveal a lot about the share price potential.
Recognising what makes up good fundamental health can help you choose a winning growth stock. Any fundamental analysis or technical analysis of a stock should cover the following areas:
- The Balance Sheet: The statement of financial position… It’s all in the name. Showing all of the assets, liabilities, and capital that the company owns at one specific point. Every financial transaction can be tracked through a companies balance sheet.
- Cash Flow Statements: Cash flows track the net movement of money in or out of the company. Cash flow is the main key to a company’s growth. Generating a consistent and sustainable positive cash flow is a good indicator of solid financial health which usually leads to share price growth.
- Income Statement: Commonly named the ‘Profit & Loss’, the income statement shows a business’s revenue, expenses, and overall profit for specific time periods. Economists look at the income statement as the most important document to look at.
This is a basic of the documentation you will analyse when researching a company’s fundamentals. Used properly, they can tell an investor the ability the business has to generate profit, manage debt, and use cash flow correctly to grow the company.
Important Message: Don’t just look at one or two years of fundamentals, go back at least five years to get a full grasp of what the business is doing, and if the growth has already started.
Avoid Overvalued Stocks
How can you tell when you’ve missed an opportunity? You’re late to the party, the share price has already appreciated quite a bit, and you’re scared it’s reached its peak.
Because growth stocks are highly desirable they can tend to become overvalued, which means you should not be investing in them. Growth stocks that are overvalued will likely see a decline in share price and eventually trade at a price that reflects its current fundamentals.
This equals bad news for growth investors. Price-to-Sales ratios and Price-to-Earnings ratios can be good tools to take a look at when investigating a growth stock.
Reasonable P/S ratios with expectations of high sales growths can be a good sign for the future of the stock. Also a flat P/E ratio that is below the historical average for the stock can mean the share price has more room to grow.
Another great way of determining if a stock is overvalued is by using Warren Buffett’s Intrinsic Value calculation.
Tools Available to You
Stock screeners will be one of the most reliable sources that you use to find growth stock ideas, most of them are free as well!
One of my personal favourites is Finviz. It might look intimidating when you first go to the website, but I assure you, it is easy to use. Finviz has data on more than 7,300 companies and investors can input specific parameters to help them find stocks that fit their criteria.
Finviz does have a free version, however if you are looking for an edge in the market you can buy the elite version for $24.96 per month.
Anyway, here are a few parameters I set when screening for growth stocks:
- Market Cap: Since I don’t deal with penny stocks, I stay tend to stay away from micro-cap companies. A baseline market cap that I use is $300 million, that way I don’t get shown the tiny companies.
- Profitability: Companies showing a consistent profit are better choices for growth stocks. An easy way to weed out the companies making a loss is to set the P/E ratio parameter to be a positive number.
- Industry: I don’t want to know about boring industries, or industries I know nothing about. So I simply input the industries I want to look at, and that’s all I see.
- Balance Sheet: While debt isn’t a bad thing for companies that expect to grow, we do want to worry about companies that can’t afford their liabilities. The debt-to-equity ratio measures the amount of capital a business has compared to its outstanding debt. A good rule of thumb is to stick with companies that have a debt-to-equity ratio lower than 30%.
- Projected Profit Growth: This is only available on the elite version of Finviz but it is worth it. Wall Street analysts are paid hugely to predict how much a company will grow in years to come, this is specified by a growth rate. While the analysts can be wrong, it is a good indicator of the confidence the market has in a company. I normally look at companies with a growth rate of 15% or higher.
On September 10th 2020, after putting these parameters into Finviz, the stock screener gave me 66 potential companies to invest in. There is no bullet-proof formula that says which of the 66 are going to be winners, but out of 66, there is always a few that stand out.
Example of Finviz
Like I said, I use Finviz to screen for potential growth stocks on a regular basis, I have an elite subscription to the software because I can justify the cost based on my investments. But the free version is still a good place to start.
Finviz pointed me in the direction of HealthEquity (HQY). Just quickly looking down the list of companies Finviz had suggested, I learned that HealthEquity’s revenue and profit had compounded at 38% and 57% over the last five years.
Because these are fantastic indicators, I dug deeper into the financials of the company and long story short, this is the conclusion I came to:
|HSA Accounts||2.14 Million||2.75 Million||3.40 Million|
|Custodial Assets||$3.7 Billion||$5.0 Billion||$6.8 Billion|
HealthEquity operates a platform that is used to manage Health Savings Accounts (HSAs). These accounts allow employees with high-deductible healthcare plans to completely avoid paying taxes on their healthcare costs.
The rising popularity in HSAs over the last 5 years led to a massive increase in users on HealthEquity’s platform. This all means:
- HealthEquity has a bigger audience
- HealthEquity has a higher profit
- HealthEquity has a more positive cash flow
Fixing a problem for people with healthcare plans created a massive opportunity for investors… HealthEquity’s share price went from $40.88 in September 2017, to $97.07 in September 2018. (Thanks Finviz)
The Risk Involved with Growth Investing
All investing carries risk, but growth investing can be on the high side of the risk spectrum.
When Wall Street thinks a company will grow rapidly, and increase profits ahead of the market, they usually award the company with a high valuation. The catch-22 is… The higher the valuation, the more it stands to fall, hence massively increasing the risk of the investment.
I’m going to circle back to HealthEquity for a second. At the time of this article, HealthEquity is trading for more than 100 times its trailing earnings, and 21 times its sales. For those new to growth investing, those numbers are sky-high compared to the average business on the S&P 500.
This significantly increases the risk of investing in HealthEquity, if the company fails to meet Wall Streets growth targets, the share price could see a massive decline.
Another risk factor investors must be aware of is… Growth stocks are more likely to experience huge price swings. Because of the reasons above, growth stocks are more volatile, which can be unnerving.
Because of investors emotions, people can sell at small profits, fearful that the company will fall. While others see opportunities to increase positions at lower prices. All of this can lead to uncertainty in the market.
What are the Experts are Doing
Wall Street fund managers have huge research budgets, and a lot of experience in finding growth stocks. The big money managers are required to report all holdings to the SEC every 90 days, it can be an eye-opening read to find out what they are buying and selling.
Not every fund manager is worth following, but if you can find one with either, a consistent profit, or someone with the same core investing values as you, it’s worth checking out what they’re into.
My favourite growth investors that I follow are:
- Pat Dorsey (Dorsey Asset Management): Dorsey was the director of equity research at Morningstar for over 10 years, he has written 2 books on growth investing which are a must-read. But now he owns his own asset management business where he makes concentrated bets in growth stocks, that he believes will generate wealth for investors in years to come.
- Carl Icahn (Icahn Capital Management): Icahn has a publicly traded investment company called Icahn Enterprises (IEP). He has enjoyed market beating returns and has a net worth of $18 billion, this is all down to his ability to find undervalued stocks. Recently he has become an activist investor, buying meaningful positions in a company, then shaking up the board members to try and improve the business. His style of investing is not for everyone, but I find it entertaining to look at his portfolio as there is always a red heron somewhere.
- Chuck Akre (Akre Capital Management): Running the FBR Focus Fund from 1997 to 2009 with annual returns of more than 12%, Akre’s experience in the market is second to none, since the average annual return during that time was 4.4%. Launching his own mutual fund in 2009, his investing style is to buy growth stocks and never sell.
There are also plenty of websites that offer growth investing advice, such as Whale Wisdom and TipRanks. These two websites in particular, have news updates on what the big money spenders are doing in the market, which they then use to calculate their own stock picks.
Read as Much as You Can!
Educating yourself on the subject of growth investing should be your number 1 priority if you want to be successful.
“An Educated Growth Stock Picker, is a Good Growth Stock Picker”Chris Race – Right Now!
Digesting content such as this article, books we’ve mentioned such as Pat Dorsey’s, Benjamin Graham’s, and Warren Buffett’s, then putting what you have learned into practice is essential to mastering your skills.
You’ll learn a lot from books, you’ll learn even more by researching the market and following through the growth investing journey.
Is Growth Investing for You?
Nothing about finding good quality growth stocks is easy!
You don’t have a crystal ball telling you which startup is going to become the next Amazon. But, what you can do is, vastly increase your chances of finding good stocks by applying strong fundamental analysis, recognising profit trends, and learning as much as you can about the subject.
With new tech being created everyday, and even more companies with new innovative ideas, the growth stock selection is getting bigger and bigger. If you prefer a more passive investing style, get into dividend stocks, but for a journey of huge value, get into growth stocks.
Using the methods in this article will massively impact your success in finding potential companies. But finding growth stocks is one thing, having the nerve to hold onto them is another… Once you gain the experience and emotional stability to hold a growth stock through thick and thin, you can do anything.
If you master your techniques, you are opening yourself up to massive wealth in the future.