Growth stocks are the high fliers and derive their name from growing at a much faster rate than the broader markets. Investors who buy growth stocks are looking to exponentially grow their original investment in the future through capital gains. They often share many of the same characteristics and are generally more popular amongst younger investors. Since there is an inherently higher risk level, they are also preferred by high-risk high-reward investors.
What Are Some Characteristics of Growth Stocks?
So how do you spot a growth stock? You could just look at the sector the stock is in, but that does not always tell you the full story. Are all tech stocks growth stocks? Would you consider Apple a growth stock? Company size is an important factor and one of the things you need to look at. The mega-cap tech stocks have long been considered growth stocks, but how much larger can they grow to? These are all things you need to take into account before investing in growth stocks.
Growth stocks are often juxtaposed with value stocks. What is the difference? Here are some sectors for each group that will make things a little easier to understand:
|Sectors||Technology, Software as a Service, Electric Vehicles, Cloud Software, Data Analytics, Fintech and Digital Payments, Biotech, Genetics, SPACs||Banks, Consumer Products, Industrial Conglomerates, Retail, Restaurants, Energy, Transportation|
This is not to say that one type of stock is better than the other though. In fact, a well-diversified portfolio should have some of both value and growth stocks. Ultimately, which stock you choose may just come down to things like your age, risk tolerance, and investing goal.
Not Profitable, Yet
This does not apply to every growth stock, but it is true for a majority of them. Why are growth stocks not profitable? Growing a business is difficult and it takes a lot of capital investment. Any revenues the company makes are most likely being dumped right back into growing the business.
Scaling a business is one of the costliest processes in a company’s infancy. Just look at how long Amazon took to become a profitable business. Bezos founded the company in 1994, and the company did not turn a profit until 2001. In 2001, Amazon had a market cap of around $4 billion. So for seven years, Amazon took every penny it made and put it back into scaling the business and developing the global eCommerce monster it is today.
Growth Stocks Are Usually Young Companies
The companies that grow fastest are often in their infancy, or at the very least, new to the public markets. If a company can sustain growth at the expense of profits, it’s stock price will generally rise. This is because the stock market is a forward-looking vehicle that wants to see where a company is going rather than where it currently is. But why are most growth stocks from young companies? The answer is in the next characteristic.
Growth Sectors Are Not Fully Developed
Investors know that getting into sectors before they get big is a great way to make massive returns. Finding future secular trends before they become trends.
Investing in Tesla before electric vehicles and renewable energies became the standard. Buying into cloud computing before anyone else knew what it meant.
Entering into digital payments, while everyone else was still investing in banks. Chances are if you invest early into a growth sector, that sector still has a lot of growing to do.
This ties back to the market being forward-looking! Genomics is just now getting mainstream attention.
But it could very well be the future of our healthcare system. Electric vehicles used to only be Tesla, and now every automaker in the world is making them. In the long run, a growth sector may look very different from when you first invested in it.
Growth Stocks Trade at High Multiples
Calculating multiples for stocks is a tried and tested method of fundamental analysis. But with the rise in tech stocks that saw exponential growth that has never been seen before, price multiples soon became nearly irrelevant. Generally speaking, growth stocks trade with a high price-to-earnings ratio. Why is that?
It’s because growth stocks can have relatively low earnings at this stage in their life cycle, and yet still have a high stock price. Again, the market is forward-looking. Stock price is a function of future growth, while earnings is a function of present performance. Put those two together and you get high price multiples.
Growth Stocks are Volatile
This is why I started that growth stocks are inherently riskier than value stocks. Since forecasting is based on forward-looking expectations, downside risk can come swiftly if those expectations are not met. This can cause sudden dramatic price drops following a disappointing earnings report or a decline in performance. On the other side of the coin, growth stocks can bring massive gains in a short amount of time. If you don’t have the stomach for this type of volatility, then growth stocks aren’t for you.
What Are the Best Growth Stocks?
Tesla (NASDAQ: TSLA): It seems like the term growth stock was made to define Tesla. The electric automaker is the definition of a growth stock, and shareholders can tell you all about the volatility. Tesla is not profitable, in a growing industry, and trades with a trailing P/E ratio of 650, and a forward-looking P/E ratio of 105. In case you were wondering, those are some gaudy multiples. Yet, you will rarely meet an investor that doesn’t see the long-term potential in owning Tesla. The stock has already gained more than 3,500% since the start of 2020, and arguably has one of the longest runways of any company in the world.
Palantir (NYSE: PLTR): One of the most polarizing stocks on the market, Palantir made its public debut back in September 2020. Since then, the stock has returned 137% compared to 35.5% by the benchmark S&P 500 index. Palantir is in the field of data analytics, a sector that has a lot of growth potential in the future. The company is not yet profitable. In fact, has seen its losses widen as it scales its operations further. Palantir is also not a young company, as it was founded following the 9/11 terrorist attacks in September 2001. The stock currently trades at a forward-looking price-to-earnings ratio of 110 and a price-to-sales ratio of 35. The multiples are high, but the future potential for Palantir’s success is undeniable.
Growth Stocks to Consider
Crowdstrike (NASDAQ: CRWD): We are just scratching the surface in terms of how important cybersecurity will be in the future. An increase in cyber attacks like the Colonial Pipeline hack and the recent Kaseya Ransomware attack has placed the focus on cybersecurity companies. Crowdstrike is one of the leaders in endpoint security and cloud protection. The company already works alongside brands like AWS, Google Cloud, Zscaler, and Okta. Crowdstrke also trades at a forward-looking price-to-earnings ratio of 370. Yeah, that’s pricey. Still, the market obviously recognizes that Crowdstrike is one of the best at what it does. You often pay high prices for the best companies, and Crowdstrike is an excellent example of this.
Shopify (NYSE: SHOP): Another high-growth stock that has continued to rise, blowing past all reasonable valuations. Shopify’s eCommerce platform is the industry leader in helping small businesses set up online storefronts. The stock’s rapid growth over the past few years is an excellent example of how forward-looking markets and high-quality companies can lead to inflated stock prices. Shopify is already profitable and has a market cap of nearly $200 billion, so it’s not your traditional growth stock. Despite this, it trades with a trailing P/E ratio of 124 and a forward-looking P/E ratio of 319. Shopify could be a $1 trillion company in the future, and yet to invest now, you pay like it already is.
It’s easy to see why growth stocks are popular, especially amongst younger investors. If you have a long time horizon, you can wait for the company to reach its full potential. When you are younger, you also have more time to make up for a missed investment. Not all growth stocks return exponential gains. Some can fizzle out and decline, and some can trade sideways for years. But if you can choose a few growth stocks early enough, they can provide life-changing returns.
Growth stocks often take patience to hold through pullbacks and volatility. It’s never a straight lineup and is almost always a chart that has numerous ups and downs. If you love a company, be patient with it. Apple was just a run-of-the-mill computer company until it created the iPhone. Facebook was a social media platform until it bought Instagram and Whatsapp. Amazon was an eCommerce company until it started AWS. Companies evolve, and if you can see the long-term growth potential, your investment will reap the rewards.