Investors, no matter how experienced, will likely have heard of many of the world’s top growth stocks. These typically include technology stocks – although growth stocks aren’t limited to that one sector by any means.
So, companies such as Netflix Inc (NASDAQ: NLFX), Amazon.com Inc (NASDAQ: AMZN) and Tesla Inc (NASDAQ: TSLA) are all prime examples of growth stocks.
These types of stocks all likely have the same features in common; high revenue growth, a large total addressable market (TAM) and rapid adoption of their offering.
Many of the best growth stocks are found in overseas markets, particularly the US and Hong Kong given their exposure to the world’s two largest economies.
How to approach investing in growth stocks?
Growth stocks can be found anywhere. The quality and growth potential of them, however, can differ greatly.
Before investing, it’s important to understand what sector the stock operates in. Does it have a long runway for growth? Is it a market leader? Is revenue growth sustainable? Are there structural tailwinds to this growth and how permanent are they?
These are all questions to pose before thinking about investing in any particular growth stock. However, one of the most overlooked one is: can this company disrupt its industry?
For example, back in 2000, no one would have thought that a little-known DVD mail-order subscription service, Netflix, would be able to take on the giant of the film rental market, Blockbuster.
However, fast-forward to today and Blockbuster went bankrupt in 2010 while Netflix’s share price has risen by thousands of percent given its dominance in home entertainment.
What was the catch? Netflix saw the future of entertainment being at home and charging a subscription service for this. Meanwhile, Blockbuster’s whole revenue model was built on charging late fees to its customers returning rentals – something that wasn’t sustainable.
This is just one example of how businesses can change quickly. Ensuring a business model is future-proof and also generates value to its clients is important.
It’s also important that you do not exclude growth companies solely because they are unprofitable today.
In fact, many of the world’s greatest companies, including the likes of Netflix and Tesla, started out life unprofitable.
However, over time their metrics will likely improve and they can turn revenue growth into real profits.
Investors need to take a longer-term view – while perhaps ignoring the short-term losses that companies can generate – and ensure that the growth stocks they invest in have a future path to profitability.
Why invest in growth stocks?
The answer to this is simple. The right kind of growth stocks, i.e. the successful ones, can return to investors many multiples of their initial investment. Hence, the name “growth”.
There’s certainly a place in every investor portfolio for growth stocks, dividend stocks, value stocks and exchange-traded funds.
However, because growth stocks are typically seen as more risky (but also much more rewarding, remember) younger investors tend to have a higher portion of them in their portfolio versus someone who may be approaching retirement.
That’s because they offer the biggest upside in terms of capital appreciation over the long term. If your long-term time horizon is at least 10-20 years then the best growth stocks can offer outsized returns.
Metrics to identify growth stocks
Before starting to invest in growth stocks, there are a number of metrics that you should be familiar with when assessing the growth potential.
As long-term investors, we want to identify great growth companies and hold them for the long term – just like any other type of stock we purchase.
Here are some key metrics to monitor when deciding which growth stocks to invest in:
This is basically the company’s revenues minus the cost of goods sold (COGS). Displayed as a percentage, gross margin gives you an idea of how much of each dollar in sales it can keep.
Ideally, gross margins should be getting higher as the company gets older. That’s particularly true of companies in the tech sector. That’s because companies scale at very low cost in the technology sector, which should contribute to a higher gross margin over time.
This is a somewhat crude measure but it’s also a useful guide to see how fast a company is growing its sales. Ideally, growth stocks in their early years should continue to post year-on-year revenue growth that is increasing.
However, investors need to remember that as companies get bigger, their revenue growth rate (in percentage terms) will inevitably slow. Yet for growth stocks, even if the rate of growth slows, we should expect there to be growth of some sort.
Price-to-sales (PS) ratio
For many growth stocks (particularly those in the tech sector), they may not have any profits to speak of. That makes the price-to-earnings (PE) ratio, in effect, useless as a way of measuring valuations of growth stocks.
So instead, the price-to-sales (PS) ratio is a better measure of how “expensive” a growth stock is. This is calculated by taking the company’s market capitalisation and dividing it by its total sales in its past 12 months.
For example, if a company has a market capitalisation of US$20 billion and had sales of US$800 million in its previous 12 months then it would have a PS ratio of 25x.
Benefits of growth investing
Growth investing is one of the best ways to build wealth over the long term. That said, investors also need to be comfortable with volatility in share prices.
That’s because the share prices of growth stocks typically fluctuate much more than, say, dividend stocks.
Taking Amazon.com Inc (NASDAQ: AZMN) as an example. Back in late 2018 the e-commerce and cloud computing giant’s share price dropped by more than 30% from a high of US$2,000 a share to around US$1,380 – all in the space of three months.
But where does it sit today? Above US$3,400 per share. It’s a vital lesson in understanding that volatility is just a natural function of the stock market.
To be able to earn higher returns, you have to be willing to tolerate potentially higher volatility. However, at the end of the day, buying great growth companies and leaving them to multiply your investment over the years is the real key to the appeal of growth investing.