Growth investing can be considered investing in things you believe will increase in value or investing in things that will increase the value of your investment account.
Let’s start with different types of growth investing looking at investments that can increase in value.
Growth Investments
When investing in growth investments, the underlying investment needs to have a reason to increase in value. Remember in the Economics 101 course. Supply and demand drive everything. Growth investors want to buy an investment today with hopes that investors will want to pay more for the same investment in the future when the original investor wants to sell it. Growth investors are looking for capital appreciation.
When thinking about the capital appreciation of an investment, most people will think about investing in stocks. Stocks are representations of companies. Investors in stocks hope that the company will grow over time, thus increasing its intrinsic value. If a company grows profits from $1 million per year 10 years ago to $10 million per year today, one would think that the company is worth more today. The company doesn’t even need to pay dividends, but the facts that the company generates higher profits or cash flows will naturally cause investors to think the company should be worth more today than it was 10 years ago when profits were a lot lower.
In publicly-traded companies, growing companies with growing profits and cash flows can push the price of the stock higher over time. In simplistic terms, this is what growth investors are looking to try to take advantage of. Growth investing has a lot of assumptions that need to come true (growth rates, investors wanting to pay a higher stock price), which often results in higher volatility relative to other investment styles (value, income, total return).
Types of Growth Investing Styles
There are different types of growth investing sub-styles that investors can consider: conservative growth, traditional growth, aggressive growth, speculative growth and growth at a reasonable price (GARP).
I’ve covered institutional growth equity managers for many years and if you are investing in actively-managed growth strategies, understanding their sub-styles is extremely important. If you are using Morningstar or some other investment manager research tool, you can’t just utilize the investment category (i.e. Large Cap Growth), you need to understand the type of growth manager it is. Understanding the growth sub-styles below can help.
Conservative Growth
Growth is growth. Conservative growth can be lower growth companies with higher probabilities of achieving that growth. These may be slower growth companies, including companies that are growing but also pay dividends. Companies like regulated utilities could fall in this category, although a slow growing tech company could as well. A lower growth rate and higher probability of sustainability often results in a lower volatility growth stock.
Traditional Growth
This can be companies with a big higher growth that conservative growth companies. These companies could grow in the 5-10% range but still have higher probabilities of sustainability over a period of time.
Aggressive Growth
Investing in these types of companies may have growth rates over 10%, but the sustainability of those growth rates may be more uncertain. Companies may still be profitable but some might be a bit more speculative and may not be profitable over the short-term, but should be over time. Aggressive growth companies can have a shorter-period of very fast growth, but anticipate to get to a more traditional growth level over time.
Speculative Growth
This is a category with companies that may have very high rates of anticipated revenue growth, but may not be profitable over the near term. These companies may include start-ups, new technology or medical companies, or any other companies that may have an interesting product or service with a potential demand for it, but it could take some time to generate any meaningful profits or cash flow. Revenues and revenue growth can be high in these companies, but high revenue growth doesn’t have to translate into profitable companies that generate cash flow, particularly if these companies continue to reinvest in the business.
Speculative companies are often tied into “hype” and investors should be cautious in this space. Stock prices can be very volatile on the upside and downside, where big winners and losers can be found.
Growth at a Reasonable Price
Some growth investors care about near-term price, some do not. I’ve covered institutional growth managers that don’t care and those that do. Growth at a reasonable price, or GARP investing, is a growth investing style that cares about valuation. As previously stated, what you originally pay for a growth investment matters. If you can find a high quality, faster growing company that has a stock that is trading at an attractive valuation (short-term out of favor, sold off during a market panic, etc.), that is an excellent time to try to take advantage. The lower the price you pay for a high quality growing investment, the amount of risk you take of being incorrect on the growth prospects is reduced.
GARP investors often need to be patient and be wary of hype in the world of speculative growth, but investor may be well-served to consider this approach when growth investing.
Momentum Investing
Momentum investing is not necessarily growth investing, but it is often a term used in conjunction with growth investing. Momentum often refers to the persistent price movement of an investment. For example, if a stock price keeps moving up over time, it would be considered to have positive momentum. If it goes down, it has negative momentum. If a company is growing and the valuations are reasonable, one would hope the stock price will go up over time, generating positive price momentum.
Companies can also have fundamentally-driven momentum. Investment managers like to see consistent revenue, earnings and cash flow growth. If these fundamental factors can persistently show growth, this is also considered momentum investing. Sometimes growth companies go through shorter periods of trouble, but if the fundamentals shift back to positive, the change in fundamental momentum can cause a stocks price to exhibit price momentum in the future.
Challenges with Growth Investing
Future Investors Buying Higher
Growth investors need someone else to buy their investment at a higher price. Just because a company grows, doesn’t mean the stock price needs to appreciate over your particular time frame. As an extreme example, if a company grew profits and cash flows at 10% a year for 9 years, then a pandemic hits and the stock market declines 40%, but your company still grew profits and cash flows 10% in that 10th year, it won’t matter. The investors want to sell their stocks and get defensive, pushing stock prices down significantly. Again, stock prices are based on supply and demand for that particular stock at any given time. Some times it doesn’t matter what the fundamentals are.
Correctly Anticipating the Future
One of the biggest challenges with growth investing is whether or not your analysis of the potential growth prospects will meet, exceed or fail to meet the actual growth projections. If you think a company should grow 10% over the next 10 years but actually loses money over those 10 years, the odds that another investor will want to pay a higher price than you originally did is probably pretty low. You better do your homework on your investment.
Starting Valuations
What you pay for a growth investment based on potential growth projections that may or may not happen is very important.
What you pay for that growth is also a huge consideration. If you overpay for the potential of future growth and that growth isn’t delivered, you could be sorely disappointed in your actual return. Just because you think an investment will grow, doesn’t mean that it has to. If the media and investors are hyped up about the potential of artificial intelligence, and any company tied to or just saying they are tied to artificial intelligence are hyping their company up, investors’ demand for those company stocks will jump, pushing the stock prices and valuations higher.
In these hyped up markets, valuations can get so high based on future growth potential that in reality, the company may only really have a small probability of hitting those growth assumptions. In these periods, maybe the stock price gets to a 300x price-to-earnings multiple, requiring investors needed significant growth every year for the foreseeable future to “get your money back” on the investment. Remember a P/E ratio is the price of the stock divided by the earnings per share.
A better way to look at it is the inverse of that, which is the earnings yield. So the E/P ratio. This gives you a sense of how much in company earnings the company is earning for each share of the company. In the 300x P/E example, the E/P is 1/300 or getting paid $1 in company earnings per every $300 per stock purchased, or a yield of 0.3%. As you can see, investors would need those earnings to grow very quickly to get that earnings yield to something attractive. If a very fast growing company doubles earnings every year for 5 years, and the stock price stays the same, the E/P is 16/300, or an earnings yield of 5.3%. This is if the stock price doesn’t move over a 5 year period. Flipping it back to a P/E ratio, the new P/E ratio (300 price/16 earnings) is 18.75x.
Remember, in order for the growth investor to get a return on that investment, there will still need to be demand from investors for the stock to push the stock price higher. It doesn’t matter if the company doubled earnings each year for the last 5 years. If the stock stagnated at $300/share for 5 years until other investors were willing to come in at a more attractive valuation at 18.75 P/E ratio or 5.3% earnings yield, the high price the original investor paid for the high growth company wasn’t worth it for those 5 years.
Growth in your Investment Account
When investor talk about investing for growth, it doesn’t have to mean just looking for capital appreciation in their investments. It could just be focuses on the aggregate value of their account growing. If that’s the case, considering higher income generating investments is also important.
Let’s talk about income-generating investments. If you don’t anticipate taking money out of your account, and you reinvest any type of income, that income generated is reinvested in income-generating assets, which is then reinvested again. This reinvestment is growing the original income and taking account of the magic of compound interest.
If you have a longer time horizon, and you can handle some volatility, you can consider higher income-generating assets. Depending on the market environment, these higher income-generating assets can generate attractive income yields of 6%+. Some can get over 10% yields, depending on the investment. A 6-10% yielding asset could be considered attractive as a complement to equities, which may provide potential 6-8% in average price capital appreciation over longer-periods of time.
Remember, with capital appreciation investments, investors need other investors to pay higher prices for their investments than they did. With higher income investments, you are getting paid that cash flow and can do what you wish with it. For the “growth in investment account” investor, we’ll assume you’re reinvesting it to grow the account.
Higher income generating assets could include mid-quality grade bonds, high yield (below investment grade) bonds, emerging markets debt, option-income strategies, and closed end funds. These asset types have higher volatility than high quality bonds, but for the investor looking for higher returns and higher growth, these investments could be something to consider.
Other investments, such as dividend-paying stocks, REITs, preferred stocks, convertible bonds, etc. may have lower income generation but have the potential for capital appreciation as well. Investors can consider these investments more on the total return side of the investment style, which we will get into in a separate lesson.
Just remember, investors looking to “grow their accounts” don’t just need to focus on growth investments or to just focus on making money through the capital appreciation of stocks. Investing in higher income-generating assets should also be considered and can potentially provide diversification benefits, lower overall portfolio volatility and consistency of returns over time.