What are growth stocks?

Growth stocks are prized by traders and investors. Let’s examine what growth stocks are – plus how you can find and trade them.

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What are growth stocks?

Growth stocks are listed companies with share prices that are expected to rapidly increase in value. Usually, they don’t pay dividends or generate huge profits. Instead, they reinvest capital back into growing the company as quickly as possible.

To be considered a growth stock, a company’s revenues and stock price should have the potential to increase faster than similar firms in the same sector or industry. This sharply rising share price is what attracts investors, who aim to sell the stock on and profit from capital gains rather than focusing on dividend yields.

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Characteristics of growth stocks

Any listed company could be a growth stock, as long as they have the potential for sharp capital appreciation. However, there are a few characteristics that these businesses tend to share – learning to identify them is a key skill for any growth investor.  

High P/E

Growth stocks aren’t valued on what the companies earn now; their worth comes from the room they have for capital appreciation. For that reason, they’ll often have a high ratio of price to earnings.

Investors may drive up the price of a growth stock while profit remains low, in anticipation of growth. This causes P/E to rise, often well ahead of other companies in the same sector.

Some growth stocks may not earn any profits at all.

Unique product

The best growth stocks may have – or be about to launch – a product or service that no other company currently offers. If they can ensure that their product takes off before another business catches up, the potential for a long bull run is high.

Focus on spending

Growth stocks tend not to pay dividends or generate huge profits. Why? Because they reinvest all their revenue back into growing the business as quickly as possible.

A large, established company may not expect its share price to rise too quickly in coming years. So they’ll try to attract investors with strong profits and regular dividends. Growth stocks are the opposite. As these companes are generally (but not always) small, they focus on growing revenue with high R&D budgets, marketing spend and wage growth.  

Loyal customers

Evaluating a growth stock using traditional fundamentals can be tricky, so investors often look at alternative metrics.

Examining the customer base can be one useful avenue. With unique products and a strong focus on developing their output, good growth stocks tend to attract loyal customers – and are bringing more customers in all the time.

Common sectors for growth stocks

Growth stocks can come from any industry, but you’re much more likely to find one fast-growing industries such as biotech or big data, as these sectors have a high potential for expansion.

Growth sectors may be set to benefit from upcoming legislation or regulation too. Eco-friendly tech companies, for example, may see their profits leap as governments look for green alternatives to existing fossil fuels.

However, just being in a high-potential industry won’t make a company a growth stock. Typically, they’ll have a strong market share too. After all, being the fifth largest company in an expanding sector won’t necessarily mean you rise faster than your peers.

Growth stocks vs value stocks

Growth stocks and value stocks are both highly sought after, and they share some similarities. But they aren’t the same thing:

  • A growth stock is any share that is likely to display fast long-term price growth
  • A value stock is a share that is currently underpriced by the market

They suit different investment strategies, too. Hunting for growth stocks means finding companies with the specific characteristics that may soon lead to a huge rally. To find value stocks, meanwhile, you assess a company’s fundamentals to decide how much you think it’s worth. If you believe that it’s trading below its value, you buy it.

Is investing in growth stocks risky?

Investing in growth stocks can be a risky strategy for your portfolio. As with any trade that comes with a high potential return, growth investments tend to offer a high degree of risk at the outset.

Here, the chief risk is that the company never fulfils its potential to deliver capital returns. This can happen for numerous reasons: another business might swoop in and take its advantage, for instance. Or ots product might become irrelevant before it generates revenue.

Many growth stocks are new, with small market caps and little history. While that means they have more room to expand, it also increases risk. Remember, it only takes a $0.50 share price decline of a $1 stock to wipe out half your investment.

Examples of the best growth stocks

That’s all great in theory, but to really understand how growth investing works you need to look at some real examples of the best growth stocks from recent years. Let’s examine three in more detail: Amazon, Moderna and Tesla.

Amazon

  • No dividend, despite strong financials
  • High P/E
  • Growth sector: Tech

Between 2015 and 2021, Amazon’s share price increased by over 900%. In 2020 it reported net income of $21.33 billion, with free cash flow of $26 billion.

Despite these figures, Amazon is yet to pay a dividend – it attracts investors by delivering high share price growth. And with a P/E ratio regularly in excess of 80, shareholders clearly expect its stock to continue performing.

Moderna

  • Revolutionary product
  • P/E of over 150
  • Growth sector: Biotech

Moderna is an example of a growth stock developing the right product at the right time. After an IPO in 2018, shares in the company failed to take off until 2020, when its revolutionary mRNA-based vaccines suddenly hit the spotlight due to COVID-19.

By early December, the stock was up almost 800%. Sales leapt from $8 million in Q1 2020 to almost $2 billion a year later.

Tesla

  • Product benefits from regulation
  • P/E of over 1000
  • Growth sector: Electic vehicles

Tesla has been a stock market darling for several years, but like Moderna it exploded in 2020. After starting out the year worth $88, Tesla shares rose over 700% in the next 12 months.

Environmental regulation had a large part to play in Tesla’s growth. Emission credit sales helped increase revenue, with many investors hoping for further boosts from Biden’s election win in November.

In many ways, Tesla might be the epitome of a growth stock. Despite growing profits, its P/E ratio remains far in excess of 1000.

How to find potential growth stocks

To find growth stocks, you essentially want to hunt for listed companies that fit the critera we’ve covered above. How you achieve this is up to you, but some ways might be more efficient than others.

Here’s a step-by-step plan to get you started.

1.      Analyse high-growth industries

A solid first step when finding growth stocks is to look for sectors that currently have high potential for returns. These tend to change over time, so it’s worth doing research now. Desktop PCs, for instance, might have been big business a decade or two ago. But they aren’t today.

2.      Look for companies with smaller market caps

It isn’t a hard and fast rule – just look at Amazon – but smaller, newer companies tend to have more potential for growth than established players. If you’re bewildered by the number of businesses in your chosen sector, focusing on the small-cap stocks can narrow things down a bit.

3.      Evaluate by products and target market

Now it’s time to identify companies that have the potential for rapid growth. Products and target market are a good place to start. Which stocks have a product with clear demand among a wide audience to deliver spectacular returns?

4.      Check out their sales history

Once you have found a potential share to trade, you can dig a little deeper. Sales history can highlight whether a company is seeing accelerating earnings. Other factors can be important, too – such as strong leadership, audience share or high budgets for research and marketing.

5.      Are they overvalued?

As we’ve covered, the value in a growth stock is in its potential for capital appreciation. But if a business is already overvalued, then it probably won’t grow further in the future. One useful approach here is to decide your own value for stock. If it’s already close to that level, you might be better off looking elsewhere.

Trading growth stocks with City Index

If you’re ready to start hunting growth stocks, there a several resources and tools available with a free City Index account to help you out. Analyse shares comprehensive research tech, test out trading with a £10,000 demo account and view all the latest Reuters news within your platform.


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