Seeking capital gains with this popular investing style
Growth investing is a popular investing strategy which seeks out stocks that have been reporting a rapid growth in their revenue and earnings over the last three to five years. This proven track record of growth provides confidence that the company has the ability to continue to grow into the future.
These historical growth rates are used in conjunction with the stock’s future revenue and profit forecasts obtained from analyst’s estimates in order to determine the company’s future growth potential. This is an important aspect of growth investing, as growth stocks typically command high PEs. The stock price paid for its current earnings is high as investors are actually paying for the stock’s future earnings.
Example: EPAM Systems, Inc. NASDAQ:EPAM has 2016 earnings of $1.94 with forecast earnings of $3.40 for 2017 and $4.10 for 2018. The current stock price is $77.80 (Apr 25, 2017).
The PE ratio is 40 based on the last fiscal year (which is quite high), however EPAMs current 2017 PE is down to 23 and its 2018 PE is down to 19.
Growth investors generally pay premium prices for these high growth stocks, which can lead to PE ratios (Speculative stocks can have PE ratios of 100 or more). This is based on the notion that these high growth stocks deserve higher than average PEs because of their enormous growth potential and hence its future stock price appreciation.
Rationalizing the reasoning behind this is quite easy.
Example: Skyworks Solutions, Inc. NASDAQ:SWKS has a PE ratio of 20 based on last fiscal years 2016 earnings of $5.39 and has increased its earnings by 30% a year over the last five years.
At this growth rate, in three years its earnings would be $11.80 and in five years its earnings would be $20.00.
So with a current stock price of $104.26 (Apr 25, 2017) its current PE ratio is 20 (which may seem a little expensive now), however in five years time its stock price could be around $400 with a PE ratio of 20.
Thus it is not difficult to see why stock investors are attracted to high growth stocks.
While high growth stocks can provide significant capital gains, their stock price is also vulnerable to investors’ willingness to continue to pay these high PE ratios, as they are paying for the company’s future value today which may not materialize in the future.
With high growth stocks, the stock price tends to grow faster than the company’s valuation, and this leads to a couple of issues. Those stocks that do not meet analysts forecast estimates when reporting time comes, can have their stock prices reduced dramatically by investors selling out as they perceive that the company’s future growth prospects are over. Simply having a notable analyst lowering their forecast estimates can lead to a similar stock price decline. Also a stock which fails to exceed its whisper number can sold down heavily. The same can easily occur if the industry group the company belongs to or the economy in general show signs of growth slowing.
The stock prices of growth stocks are typically volatile and sensitive. Stock investors who invest in these volatile stocks need a relatively high degree of patience and to be able to psychologically handle the dramatic stock price fluctuations that accompanies this style of investing.
Characteristics of High Growth Stocks
Growth investors seek out growth stocks by analyzing the fundamental information available to them. The characteristics of high growth stocks that growth investors look for include the following.
Characteristics of high growth stocks
- High one-year, three-year and five-year historical revenue and earnings growth, which has been growing at a significantly faster rate than the economy and the industry average.
- High forecast earnings for the next couple of years that are at least as strong as the stock’s historical growth rate.
- High quarter to quarter earnings growth rates provides evidence that the stock’s growth is more consistent and continuous throughout the year.
- Expanding profit margins are desirable as this indicates that the company can produce a higher proportion of profit from its revenue.
- Are in an industry that is growing or the company has a new or improved technology, product or service.
- Tend to be smaller companies which generally find it easier to expand than large established companies. A smaller company with a new product and an aggressive marketing campaign could potentially double its profit but a large blue-chip will find this extremely difficult to achieve.
- Insiders such as directors and key employees may be purchasing stock. These insiders know the company and their own buying provides some additional confidence that the company has further potential to grow.
- Stocks with a history of reporting earnings that exceed analysts estimates on a regular basis, are demonstrating their ability to grow.
- Analyst estimate downgrades are not desirable as there is now some doubt as to the stock’s future growth prospects.
- Stock prices are generally in an uptrend which provides a lot of confidence to investors that this trend will continue.
Not all good growth stocks will necessarily display all of the above characteristics, however the more characteristics a stock has then the chances of its future success is increased. Certainly all growth stocks must be fundamentally sound and have a solid history of earnings growth to even be considered a growth stock. Conducting a through fundamental analysis will increase the likelihood of success and it is also prudent to check the company’s Z-score for its bankruptcy risk.
Growth investing involves tracking each quarterly earnings report to determine whether the stock still has sufficient future growth potential and if not, then the stock is sold and another growth candidate is selected in lieu. Growth investing is generally not suited for the buy and hold investor due to the high risks of the stock’s price collapsing.
Growth stocks should be fundamentally sound
and have a solid history of earnings growth
To mitigate the high risk involved in growth investing, most professional stock investors who hold growth stocks have an exit planed in the event something dramatic happens that would cause the stock’s price to decline significantly. Their exit strategies range from exiting when a reduction in earnings or revenue growth is experienced, through to using price stop levels where the stock is sold when the stock’s price drops by a certain percentage.
Once a growth stock portfolio is setup it does not require a lot of ongoing portfolio management, since by the very nature of investing in the company’s future growth, which takes years to evolve and as such growth investing is generally a medium-term to long-term investing strategy.
To summarize, growth investing during buoyant economic times can be extremely profitable, which certainly contributes to this strategies popularity. However caution needs to be exercised when any factor that would reduce or halt the growth of these companies emerges, which can make this strategy quite risky if the stock is not sold as the ensuing price declines can be dramatic. Some of the spectacular price declines in history have seen stocks lose 90% and more from their peak. Growth investing is only suited to bull markets and some investors make use Dow Theory to determine whether market conditions are favorable or not.