What Is a Growth Stock?
Long-term investors thrill at the discovery of a promising new company on the rise. These companies are often industry innovators with unique product lines at the forefront of change: Think of the way Tesla (NASDAQ: TSLA) revolutionized automobiles, or how Alphabet’s (NASDAQ: GOOG) algorithms forever changed the internet. They attract the market’s attention and, in turn, deliver solid returns—and they are known as growth stocks.
Growth stocks are characterized by above-average profits or revenues and usually trade at high price/earnings valuations. They could be small startups or more established large-caps. Because the market is constantly assessing their performance relative to analyst expectations, they could experience greater volatility than other types of equities, like value stocks. Unlike value stocks, growth stocks do not typically offer a dividend because their profits typically get reinvested to continue growing the business.
Often, the key to growth stocks’ valuation lies in the future rather than what’s happening in the present. Growth investing, therefore, is the practice of identifying companies that have above-average earnings potential.
Example of Growth Stock
One of the best examples of a growth stock is Apple (NASDAQ: AAPL). This company has a consistent record of double-digit earnings growth and introducing new product lines like the iPod. Even after new products are launched, more always seem to be in the pipeline, such as the iPhone, and, later, the iPad, long giving the company a competitive edge.
How Can I Identify Growth Stocks?
Investor’s Business Daily developed a list of criteria to help investors identify growth stock superstars before they make their ascent. The criteria were developed in the 1950s but are still in use today. Its short-hand acronym is CAN SLIM:
- Current quarterly earnings: The company should have at least 25% year-over-year earnings growth.
- Annual earnings growth: These should be up 25% over three years, with 17% annual ROE.
- New products or services: What’s in the pipeline for the company is what will drive future growth.
- Supply and demand: Investors should watch trading volume as an indicator of supply and demand.
- Leader or laggard: Usually, this is discerned by the stock’s relative strength versus the S&P 500.
- Institutional sponsorship: Which institutional investors own this stock? If pensions and mutual funds are investing in the company, odds are good that individual investors will want to as well.
- Market direction: In general, broader stock market trends are an important indicator for growth investing. Bull markets are more favorable periods for growth stocks than corrections or bear markets.
What Are Some Risks Associated With Growth Stocks?
Without the ballast of a dividend, growth stocks are inherently riskier than value stocks, although their upside potential is much higher. Yet, what happens if the company fails to deliver on its promises, and earnings miss expectations? Because of this uncertainty, growth stocks usually see wider price swings than value stocks, so long-term investors should be prepared to weather the volatility.
One way investors can reduce their risk is by investing in growth-related exchange-traded funds (ETFs) or mutual funds. Both can contain hundreds of stocks and thus see less drastic price swings. T Rowe Price, Vanguard, Fidelity, and Charles Schwab all offer growth stock mutual funds.
Growth Stocks vs. Value Stocks: What Are the Differences?
Growth or value? It’s a debate as old as time, but what kind of stocks to invest in all depends on what type of investor you are and what your risk tolerance is.
A value stock is a stock whose current share price is trading below its intrinsic value. The market perceives the stock’s prospects as less exciting than those of its peers, and it is priced accordingly.
Unlike growth stocks, value stocks tend to be older, more established companies, and they nearly always offer a dividend.
Generally speaking, investing in a mix of value and growth stocks is a healthy investment strategy—some financial planners advise a 50/50 mix. Taken together, growth and value stocks can make up a substantial portion of a balanced portfolio. After all, you never know where the next trend will be: Sometimes, the business cycle favors growth, while at other times, value leads. Thus, investing in a healthy mix could increase the likelihood that your returns will be consistent over the long haul.
Will Growth Stocks Recover in 2022?
TheStreet.com’s Dan Weil says that growth investing has taken the lead over value investing in 2022, and the only way the storyline will change is if there’s another Fed pivot.
