HOW TO DEVELOP A
GROWTH INVESTING STRATEGY

Growth stocks have high risk-return potential but can add significant value to a portfolio. Explore the pros and cons of growth stock investing and learn how to maximise the opportunities it offers.

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Although it is possible to witness significant losses while growth investing, investors looking to scale up on their risk-return should consider learning how to identify and trade growth stocks. 

What is growth investing?

Growth investing is a strategy used by investors to try and increase their capital using growth stocks, which are characterised by the expectation that their share price will outpace the market average. This outperformance is typically driven by the company having some form of competitive advantage that enables it to grow its revenue, profits or cash flow at a market-beating rate.

Types of growth investment

Historical data points to the fact that certain sectors or categories of firms have typically produced a greater number of high-performing stocks. Unsurprisingly, these sectors are often the first place that investors look when targeting new growth stocks. 

Small cap

The definition of a “small-cap stock” varies from investor to investor. Popular classifications include firms with a market capitalisation between $250 million and $2 billion. Alternatively, some investors identify small-cap stocks as those ranking within the bottom 10% of market capitalisation on a given stock exchange. 

Not all small-cap firms are growth stocks. However, the sector does encompass emerging firms that are currently considered to be small-cap stocks as part of their natural growth cycle, but which have the potential for significant growth.

Speculative

Speculative stocks present high risk and high reward. Their low valuation and share price often indicate that the company faces an uncertain future. For example, a speculative stock might belong to a firm with weak balance sheet fundamentals, but with a new product or business scheme in the pipeline. 

When considering investing in speculative stocks, it is crucial to identify potential catalysts that could lead to a change in the company’s fortunes.

Tech stocks

The tech sector has long been a popular hunting ground for growth stock investors. Innovative technologies, with the potential to disrupt entire industries, can enable companies to evolve from small players to market leaders. 

Apple, Microsoft, NVIDIA and Alphabet are all firms within the tech sector that started on a relatively small scale and have since achieved exponential revenue growth.

External factors

Various factors can potentially trigger above-market returns for a stock, including external influences such as economic cycles, behavioural trends and geo-political events. 

For example, stock prices in the healthcare and pharmaceutical sectors are likely to benefit from widespread pandemics, while global conflicts will likely lead to increased orders for manufacturers of military equipment, such as Lockheed Martin. 

How to identify a growth stock

It is possible to use fundamental analysis to examine the growth potential of stocks. The information found on a company’s balance sheet and income statement can reveal trends regarding revenue growth and capital investment levels.

The price-to-earnings (P/E) ratio is a metric that conveniently expresses a company’s share price in relation to its current earnings. Growth stocks typically have higher than average P/E ratios due to other growth investors having already bought into that firm, with some of the growth potential already being “priced in.”

If a stock does not pay a dividend, this is often a good indication that it might be a growth stock. Although this may deter some investors, it might signal that the company’s management has enough confidence in new projects to justify reinvesting profits, rather than distributing cash to investors.

Other methods of identifying growth stocks involve more subjective analysis. Investors should consider a company’s management changes, the development of innovative new products and societal trends, such as the move to plant-based foodstuffs. 

The intelligent investor gets interested in big growth stocks not when they are at their most popular – but when something goes wrong.

Benjamin Graham

Growth vs value investing 

Investors continue to debate the value vs growth investing topic. Growth stock investors tend to base most of their decision-making on the future potential of firms, trying to identify innovative ideas and other factors that could lead to market-beating revenue growth.

In comparison, value investors carry out a more backward-looking analysis to understand why a firm has fallen out of favour with market investors and now has an undervalued stock price. 

The value investing vs growth investing debate can often be overplayed. Despite their different approaches, both value and growth investors purchase stocks with the expectation that their price will increase in the future – the stocks usually just follow a different path to get there. 

Risks of growth investing

Like all stocks, growth stocks are exposed to market risk – the possibility that investor sentiment might shift, causing a widespread decline in stock values. That said, there are also additional risks which are more specific to the growth stock sector.

Growth stocks often have a higher-than-average P/E ratio and could be considered “overvalued” based on current earnings. This premium valuation is driven by investors seeking “the next big thing.” Unless you spot an opportunity before the rest of the market does, you will likely pay a premium to hold the stock, increasing the downside risk if things do not work out as planned.

Another risk-feature of growth stocks is that they are known for having higher than average price volatility. When the market sells off, this can lead to an uncomfortable ride for shareholders, even prompting some investors to sell out of growth stock positions at unfavourable times, increasing potential losses. Growth investors typically hold assets for longer periods and therefore require a greater deal of patience than other investors; even the strongest growth stocks can witness significant, temporary losses.

Hedging growth investment strategies

Diversifying your portfolio is an effective way of mitigating some of the risks associated with growth stock investing, but there are other approaches as well: 

• Options: Options markets in single stocks and stock indices can serve as a form of insurance. Options give the holder the right, but not the obligation, to buy or sell an underlying instrument at a future date, based on the prevailing price levels near the option’s expiration date.

• VIX Index: The VIX Index measures price volatility in the financial markets. As volatility tends to increase when asset prices are falling, holding a long position in VIX Futures could potentially help to counterbalance profit and loss fluctuations in other aspects of your portfolio.
  
• Defensive stocks: Including stocks that hold their value better than others during market downturns can complement a portfolio that also holds growth stocks. Defensive sectors, such as consumer staples, healthcare and utilities, are known for their resilience during economic uncertainties.

Final thoughts

Growth stocks can be a good option for those trying to increase the returns on their portfolio. However, since they are a high-risk proposition, many investors choose to only allocate a portion of their capital to growth stock strategies. 

Reducing overall risk levels in your portfolio by including more stable positions alongside growth stocks can actually make it easier to stay in growth stock positions, giving them the time they need to reach their full potential.

Use the eToro Academy to learn more growth and value investing strategies.

Quiz

FAQs

How can I pick the right growth stock? 

Buying exchange-traded funds (ETFs), rather than individual stocks from a specific sector, allows you to buy a basket of stocks, which increases the likelihood of you holding one that sees significant price appreciation. 

There are ETFs available that concentrate on sectors known for housing growth stocks, such as the iShares Core S&P Small Cap ETF, or ETFs that specifically target growth stocks from various sectors, such as the Vanguard Growth ETF.

What are the best metrics to use when conducting growth stock analysis?

The P/E ratio is often used as a guide because a high P/E ratio suggests that other investors are already committing to the possibility that a firm’s revenues will rise in the future. However, this metric does not work well with firms that are still operating at a loss or have negative revenues. In these cases, the price-to-sales (P/S) ratio can be used as an alternative metric.  

Are growth stocks risky?

Growth stocks are an inherently risky option. Growth stock valuations are largely predicated on the expectation of substantial future earnings. This expectation may not play out, and is made much less likely if the rest of the economy and stock market suffer a downturn.