Here is a question:
‘Is growth investing a better way to grow wealth in the stock market?’
Undeniably, the answer is yes. Many had increased their net worth via this style of investing. However, many more have failed as they achieved the opposite. To me, I believe the vast differences in investment results between the two is their own understanding of what growth investing actually is. The successful one understood it. The ones who aren’t successful have misconceptions about it.
So, in this write-up, I’ll share what I had gathered about growth investing and in brief, will offer a discussion as to whether or not you are suited for this. So here are 3 things that you need to know about growth investing.
#1: 3 Main Types of Growth Stocks
I categorise them based on their financial results. They are as follows:
1. Highly Profitable Growth Stocks
These stocks had delivered consistent and rapid growth in revenues, profits and operating cash flows. Unlike dividend stocks, they would reinvest their earnings and cash flows into their own businesses for further expansion. Therefore, they do not pay out much dividends to their shareholders, if any at all.
2. The Breakevens
I first discovered this kind of growth stock in the US market. This type of growth stock tends to report rapid growth in sales and gross profits, but would report a larger growth on marketing and R&D expenses, and hence, reporting either low profits before tax (PBT) or mostly small losses before tax (LBT). This type of growth stock does so for the following reasons:
– Increase market share of their products & services.
– Develop and innovate their products & services to remain relevant.
– Reduce tax payments to the US government.
3. The Cash Suckers
This kind of growth stock has a nice story and was able to grow its base of users and sales rapidly. However, as its name suggests, it remains unprofitable and its management team is constantly raising funds via debt and equity to stay afloat.
Thus, it would be ideal for a person to possess a higher level of accounting skills in order to invest in growth stocks.
#2: 4 Valuation Tools to Assess Growth Stocks
Basically, value investors use P/E Ratio, P/B Ratio and dividend yields in order to assess the value of a stock, particularly a dividend-paying stock. But, the 3 valuation tools above are less relevant to growth stocks.
As such, a savvy growth investor would have to study the business model of the stock to determine the relevant valuation tools to perform its valuation. So, this is not as simple and straightforward as valuing dividend stocks. To name a few, the valuation tools suitable for growth stocks include:
1. Compound Annual Growth Rate (CAGR)
CAGR is a formula to compute the growth rate of a stock’s client base, revenues and profit figures such as gross profits and shareholders’ earnings over a period of time on an annual basis.
2. Price/Earnings-to-Growth Ratio (PEG Ratio)
It compares the stock’s current P/E Ratio with its Growth Rate. So, if let’s say A1 Ltd has a current P/E Ratio of 30 and has an earnings growth rate of 30% a year, then, its PEG Ratio is 1.0. As such, growth investors could use this to compare it with other growth stocks.
3. Price-to-Sales Ratio (P/S Ratio)
This is calculated by dividing a stock’s market capitalisation with its sales for the last 12 months. So, if the stock’s market capitalisation is $50 billion today and in the last 12 months, it recorded $10 billion in revenues, the stock has a P/S Ratio of 5.0. Likewise, this could be used to compare it with other growth stocks.
4. Price-to-Operating Cash Flows Ratio (P/OCF Ratio)
P/OCF Ratio is calculated by dividing a stock’s market capitalisation with its cash flows from operations in the past 12 months. Hence, if a stock has $50 billion in market capitalisation and had delivered $5 billion in cash flows from operations in the last 12 months, its P/OCF Ratio would be 10.0 and thus, growth investors could use this to compare it with other growth stocks.
Therefore, you need higher valuation skills to invest in growth stocks.
#3: Do Growth Stocks Always Go Up in Stock Prices?
Not necessarily.
Prices of growth stocks do go up and come down just like any other stocks.
But, I have observed that they can be more volatile than dividend stocks. This is absolutely normal for there are more people who are interested in trading or in investing in growth stocks in the stock market. Other than growth investors, the people that would trade growth stocks would include:
– Speculators
– Gamblers
– Short-term traders (day, swing, scalp, position, technical, price action … etc).
Why?
This is because growth stocks are seen to be more exciting than dividend stocks as capital gains are viewed to be bigger and faster money than dividends. Some who have this view may use leverage like CFDs or Share Margin Financing (SMF) to boost their positions in growth stocks significantly so that they could achieve much higher capital gains when these growth stocks appreciate in prices.
So, with the influx of people are trade for the short-term and people who trade using leverages, prices of these stocks could rise rapidly, when the stock market is optimistic about these stocks.
But, when the stock market is pessimistic about them, it would be an avalanche as their stock prices would tumble as rapidly as they rise.
Hence, you need to have a higher degree of emotional intelligence to do well in growth investing. Otherwise, you will be severely punished.
Conclusion:
So, is growth investing suitable for you?
Personally, I believe you are ready for growth investing if you possess:
– Higher level of accounting skills.
– Higher level of stock valuation skills.
– Higher level of emotional intelligence when investing.
You need the above to do well in growth investing.
If a person does not know how to read financial statements and he claims to be a growth investor, he is not. In actual fact, he may be gambling or speculating in the stock market. Don’t admire his gains if he tells the whole world about them because most likely, he wouldn’t tell you his losses if he incurs them.
With that, I hope that you have a better understanding of Growth Investing and what it takes to be successful in it.
If you have any questions on growth investing, please post them below:
