Growth Investing Strategy: Research Plus Risk Can Mean Big Rewards

Growth Investors are constantly trying to find tomorrow's strongest stocks. They look for companies in the early stages of their growth cycle that are already showing signs of dominance. When they find a promising stock, they buy it even if it has already experienced rapid price appreciation in the hopes of riding the wave as the company grows and attracts more and more investors. There isn't a lot of analysis involved in growth investing, it is a criteria based strategy. When I say criteria based, I mean Growth Investors are much more concerned about whether a company is exhibiting behavior that suggests it will be one of tomorrow's leaders than they are about the fundamental or technical aspects of a stock.

The criteria used to select growth stocks varies widely, but in general, Growth Investors are looking for companies with the potential to dominate their category and grow earnings and revenue exponentially for the next several years. Most growth stocks offer something that gives them a unique advantage such as a cutting-edge new technology (early Microsoft Bill almost took over the world), visionary leader (Steve Jobs at Apple Inventions that start with an “I”), a competitive advantage (e-Bay will they ever have competition?), or a new and unique marketing approach (Starbucks are you selling coffee or a lifestyle?).

Investment Selection Methods

There is a little fundamental analysis and occasionally some technical analysis involved in evaluating potential growth stocks, but for the most part, Growth Investors are trying to evaluate a stock's competitive position in the market. They won't be scared away by poor fundamentals as long as their growth stock criteria are met. For example, if you have a startup with patents on a new technology, they are the first mover in a hot new industry, and they have a CEO with several successful startups under his belt, many Growth Investors will buy it even if it is in debt and losing money.

One of the fundamental metrics you will hear Growth Investors talk about a lot is the Price-to-Earnings Ratio or P/E Ratio. This simple calculation is the Earnings per Share divided by the Price of the stock and the reason they love this measure is it tells you today how investors think the stock will perform tomorrow. While some strategies would interpret a high P/E Ratio to mean a company is currently overvalued, a Growth Investor interprets this to mean that the company will earn much more in the future and that investors are simply pricing in those future earnings.

There isn't a set of rules to follow for identifying growth stocks but there are a few growth investing guiding principles that most Growth Investors adhere to. We mentioned that a growth company needs to be a leader in a new industry, so this tells you that a growth company needs to have a sustainable competitive advantage. This can come in the form of patents, new technology, deep pockets, or first mover advantage. You also know that the P/E ratio is important and this tells you that rapidly increasing earnings is a critical piece of the strategy. Something that goes hand-in-hand with rapid revenue growth is expense management. Revenue is great but if expenses are growing faster, profit margins begin to deteriorate, a common pitfall for many would-be growth stocks. Finally, if a stock is going to survive the competitive early stages of a business cycle and emerge as the clear winner, it has to have great management. Growth Investors always evaluate who is at the helm. They want to see leaders with successful track records, visionaries who are the best in their field or new and innovative business models.

Are you starting to see why we chose to review this strategy right after Value Investing? They are basically opposing strategies, what a Value Investor would consider a great stock a Growth Investor would consider trash and vice versa. Does this mean that one strategy is right and one is wrong? No, they have both proven to be market beaters over long periods of time for investors that get good at implementing their strategy. However, this certainly strengthens our recommendation of not mixing strategies, can you imagine a Growth/Value investor? Yikes.

Risks

Growth investors will experience a lot more volatility than other strategies and the market. What does that mean? That means their stocks drop first and they drop the fastest during bearish periods. This is due to the nature of growth stocks, many are young companies with high P/E Ratios and are viewed as overvalued during market corrections and recessions. Growth Investors have to be willing to ride out losses until the market turns bullish again.

While Growth Investing is not as technically or analytically demanding as a strategy like Value Investing, it is still a very research intensive strategy. Growth Investors have to keep up with more than just the market, they have to know which industries, geographic regions, and stocks are hot and they also need be aware of new technologies, services and products quickly. Successful Growth Investors are constantly shifting to different types of stocks to make sure they stay invested where there is currently a lot of interest and innovation. There is an enormous amount of information available if you're trying to figure out what's “hot” in the market right now. Every website, newspaper and magazine has a different opinion. Growth Investors have to be able to weed through all of this information and find the stocks that will be tomorrow's leaders.

Risk management is a tricky but critical component of Growth Investing. Many Growth Investors use buy limits and sell limits to stay disciplined and help deal with this constant balancing act. Properly set buy limits keep them from putting money into stocks that have already experienced most of their rally and also tell them when to take a profit. Properly set sell limits will tell them when to pull their cash out of stocks that have lost as much as they are willing to risk on that particular investment. Granted, this approach reduces your risk exposure to bad stocks, but it is disastrous if you set bad limits because growth investors lose big when their money is in cash during a rally. Growth Stocks will significantly outperform the market during bullish periods but not if your money is sitting on the sidelines.

This is not a buy-and-hold strategy, you will trade a LOT so transaction costs can add up very quickly. A good risk management program may even require that you buy and sell the same stock several times if it fluctuates through your buy or sell limits.

Benefits

Growth stocks grow much faster than other stocks, you will significantly outperform the market during bull markets. This is the goal, Growth Investors know that if they are invested in good growth stocks during rallies their huge gains will more than make up for the losses they experience during bear markets.

Growth Investors that get very good at risk management are more likely to sell out near the top of a stock's growth cycle, avoid buying when it's too late to get in, and sell a stock when it no longer appears to be behaving like a growth stock. Great risk managers will have some protection against losses plus they will always have most of their money invested during market rallies.

Let's be honest, everyone wishes they had bought companies like Google, Microsoft, or Starbucks. Growth Investing is the strategy that gives you the best odds of hitting a home run. This is one of the few strategies that actively seeks the next powerhouse stock, the one that can grow from a startup to a Blue Chip. This factor draws more people to Growth Investing than any other, many investors want to try to buy companies that make them feel like they won the lottery.

Long-Term Outlook

Growth investing isn't going anywhere, it's a very popular strategy that always draws an enormous number of investors looking for big gains during bull markets. Great Growth Investors will always outperform investors implementing other strategies. Most strategies are more conservative and provide much more protection against losses during bear markets but can't keep up with this strategy's explosive growth during bull markets because they aren't willing to take the risks involved.

One drawback of Growth Investing is that you will likely need to change strategies when you get close to retirement. As your portfolio gets much larger and as you get closer to the end of your career, capital preservation will become much more important than capital growth. Why? For example, imagine that you're only three years from retirement and a recession hits. Since you're a growth investor, your portfolio drops more rapidly than the market and you wind up losing 40% of your portfolio. If you're 15 years from retirement, no problem, you have plenty of recovery time, but since you're only three years away you are not likely to make up your losses and very unlikely to gain any more ground before your retirement date. You must then decide if you would rather work longer or manage to a tighter budget during retirement. Lose-Lose decisions are no fun, smarter investors switch to a more balanced investing strategy as they near retirement.

Investor Profile

If you choose this strategy, do several hours of research per week for the first year or two so that you can more quickly develop a knack for identifying high potential growth stocks early in their growth cycle. Study history, it can tell you a lot about how great companies behaved and were viewed by the market early on. We can't stress research and work-ethic enough. There is so much hype in the media about what stocks and industries are “hot”, and successful Growth Investors are able to ignore all the hype and find stellar companies hidden amongst the rubbish. You will have to put in a lot of hard work to refine your selection criteria and develop this talent.

You will need an iron will and a strong stomach to be a Growth Investor because you are guaranteed to take losses, often very quickly, during bear markets. Successful growth investors accept this volatility as a necessary evil and ride it out while they wait for the next rally to erase their losses. Risk management helps, but keep in mind that risk management for a Growth Investor is geared more towards timing the buying and selling of your growth stocks to maximize returns than it is toward protecting you when the market is going down. You will usually be fully invested in high-risk stocks when a bear market hits, you'll have to accept that there will be some rough patches. These fast and sometimes large losses make it very hard for all but the strongest Growth Investors to avoid making stupid investing mistakes like panicking and selling low.

A Growth Investor's goal is to identify tomorrow's greatest companies and sometimes this can feel like trying to find a needle in a haystack, you will inevitably pick losers, especially as a beginner. The only way to combat this is to continue refining your criteria and risk management techniques so that you pick fewer and fewer losers and get out of them more quickly as you gain experience.

You can expect spectacular gains from this stock market investing strategy than from any other if you master it. Investors such as the late Al Frank crushed the market averages for over 25 years. Granted, in some years he lost as much as 40% of his portfolio but when the market turned he made it back quickly. Investors like Al do their homework. He was one of the most disciplined and hard working investors to ever practice Growth Investing. He did exhaustive research and never stopped refining his risk management and stock selection techniques throughout his long and successful investing career.