You almost certainly got into the stock market to grow your money, so shouldn't you want to put that money in … well, growth stocks?
Yes. OK, probably. But it depends. It's not that straightforward.
The goal of just about every publicly traded company is to grow – grow revenue, grow profits, and hopefully, as a result, grow their share price.
The reality is much hazier. Some companies succeed with flying colors, delivering explosive sales and earnings growth for many, many years. Others manage to expand their top and bottom lines consistently but modestly. Still others go through cycles of expansion and contraction. And an unfortunate few eventually find themselves in terminal decline, never to produce growth again.
That makes researching and selecting growth stocks much more difficult than meets the eye.
Today, we'll explore the concept of growth investing, including how it's defined, why investors are drawn to it, ways in which investors evaluate growth, and how to find the best growth stocks to buy.
What are growth stocks?
Growth stocks are – and we promise this isn't a cop-out answer – stocks that exhibit growth characteristics.
You'll find similar language in prospectuses for growth funds, whether they're actively managed or ones that track an index. And depending on the fund, those characteristics will be different.
Among some of the most common growth metrics?
Revenue growth: How rapidly is the company improving the rate at which it sells its products and/or services? This is as simple as growth gets. You don't factor in any other lines on the income statement. You just look to see whether the money the company brings in is bigger than it was before.
Earnings growth: How rapidly is the company improving its profits/earnings/net income? On the one hand, this isn't as direct a measure of growth, as it also factors in things like cost of revenue, operating expenses (like R&D), taxes, interest and more. On the other hand, a company eventually needs to be profitable to remain in business. Earnings can be reinvested to spur additional growth, or stashed away as a safety net during more difficult times. Also, profits eventually can be redistributed to investors in the form of stock buybacks and dividends.
Free cash flow (FCF) growth: Speaking technically for a moment, net income is an accounting metric – one that can be manipulated by all sorts of one-time events. Cash, however, is real, tangible, in the now. Free cash flow is the money left over after a business pays its operating expenses and any capital expenditures. And some investors prefer to see growth in this metric because, unlike net income (and, to an extent, even revenue), it can't be easily skewed by accounting adjustments.
Net profit margin: This metric speaks to how well a company can turn revenue into profits. It's determined by a host of factors, such as pricing power, input costs, efficiency of operations and more. While net profit margin doesn't necessarily look at growth, having a high net profit margin typically leads to excess earnings, which as mentioned above, can be plugged back into the company to spark even more expansion.
Return on equity (ROE): ROE is another measure of profitability. You calculate ROE by taking a company's net income and dividing it by shareholders' equity. The general idea here is that the higher a company's ROE, the better job management is doing at turning equity financing into earnings.
Not only do different investors favor different growth characteristics, but they might also favor different time elements.
For instance, some funds will invest in stocks where, say, the past year's earnings, revenue and free cash flow growth exceed certain thresholds. Others will only invest in stocks where long-term projections for earnings, revenue and FCF growth clear a certain bar. And some will combine the two, perhaps demanding its holdings exceed a certain historical return on equity while also requiring holdings to have a certain level of estimated earnings and revenue growth.
You've heard the saying "past performance isn't an indicator of future returns." That goes for a company's operational results, too. A company that grew revenue by 30% last year isn't guaranteed to grow it at all this year, so past data can be a flawed way to evaluate stocks. On the other hand, estimates are clearly less concrete than actual results – and while Wall Street professionals do their best to get it right, companies can and do miss expectations.
Past financial metrics, there are other qualities investors want to look for when evaluating growth stocks. These include innovative and even disruptive products (products that are either better than those that currently exist, or products that define a new category and make other products obsolete), strong competitive positions (a unique value proposition that other companies can't match), and visionary founders, CEOs and other management.
Growth stocks vs value stocks
The U.S. stock market alone consists of more than 12,000 publicly traded equities. That's a simply undigestible number of potential investments with no real common thread, so investors tend to slice and dice them to get to smaller, more defined groups in order to find the best stocks to buy.
And one of the oldest market divisions is between growth stocks and value stocks.
Value stocks are companies that the market believes are underappreciated – that they trade below some inherent measure of value. Growth stocks aren't inherently the opposite of that. Growth stocks are merely defined by their growth attributes. But while growth stocks can be undervalued, they typically aren't – indeed, they're usually overpriced – and thus growth and value stocks are considered opposite sides of a coin.
Why do investors buy growth stocks?
The answer here is pretty straightforward: If a company is expected to grow its revenue, profits and other metrics over time, it (and thus its shares) should be worth more over time – allowing investors to sell their stock for a better price down the road.
Growth stocks, which in theory should flourish at a faster pace than other equities, have the potential to deliver a higher degree of growth, a more rapid pace of growth, or even both.
Historically, though, growth stocks' performance is cyclical, experiencing years' worth of outperformance vs value stocks, but also suffering yearslong slumps compared to their cheaper brethren.
In a short whitepaper, Hartford Funds outlines a couple of examples: "Growth stocks outperformed in the '90s during the dot-com era and have performed extremely well for more than a decade. Value stocks outperformed from 2001-2008 as investors placed a greater value on dividends and stock valuations."
And even during the most favorable periods for growth stocks, they still come with outsized risk. Especially if growth equity is determined by estimates for swift operational improvement. Should the company report substandard results and fall short of expectations, investors might rapidly sell off shares and begin searching for other growth opportunities.
How to find the best growth stocks to buy
Sure, you can buy up large-cap stocks in bulk via growth ETFs and mutual funds. Indeed, more risk-averse investors would do well to do that because it can lessen the chances that disaster in one or two equities will destroy a significant portion of their portfolio.
But if you're risk-tolerant and looking to generate some outperformance in your portfolio, concentrated investments in one or a couple of individual stocks will do the job more effectively.
And we can help you start your search with a basic quality screen.
To get to the following list of growth stocks, we've looked for companies …
Within the S&P 1500: The S&P 1500 is made up of the S&P 500, S&P MidCap 400 and S&P SmallCap 600. In other words, our search will include a wide variety of large- and mid-cap stocks, as well as the market's larger small-cap stocks.
With a long-term estimated earnings-per-share growth rate of at least 15%: Because we're looking for growth stocks to invest in, and not just short-term trades, we want to set a high bar for earnings growth across several years. (Just remember that expectations aren't a guarantee of results.)
With at least 10 covering analysts: We'd like to look at stocks that are on Wall Street analysts' radar, which makes it likelier that there's both more reporting and more insights on these companies. The more research we have at our disposal, the more educated a decision we can make.
With a consensus Buy rating: All of the stocks must have an average broker recommendation of 2.5 or less within S&P Global Market Intelligence's ratings scale. S&P Global Market Intelligence converts analysts' ratings into a numerical scale. Anything with a score of 2.5 or less is considered a Buy. Every stock that made the list has a score of 1.5 or less, which is considered a Strong Buy – the highest designation – meaning they're some of analysts' top stocks to buy.
And here's the resulting list:
