What is growth investing and why investors use it to select stocks

Growth investing is an investment strategy where investors typically invest in growth stocks seeking capital appreciation over the long term. Therefore, to understand what is growth investing, we first have to understand what is a growth stock.

What is growth stock

Growth stocks are shares of those companies which uses most or all of their earnings and resources to expand market share by investing in its products and services to generate more revenue.

These companies always look for opportunities to invest in the next big thing which has a better margin and growth potential. They do not distribute most or all of their earnings in the form of divided, instead they prefer to reinvest in the company business to maximize shareholders wealth.

These companies perform better when overall stock market is rising. They under-perform when stock market falls due to economic downturn or any industry related issues.

Here is a list of characteristics of a growth stock;

  • Strong return on equity or ROE in comparison to industry standards.
  • Higher earnings per share or EPS and strong forward earning growth.
  • High PEG ratio.
  • Strong operating profit margin.
  • Earnings grow faster than most other stock and earnings are expected to increase at an above average rate in comparison to the industry standards and overall market.
  • business generates significant positive cash flows and earnings at a faster rate than the overall economy.
  • pay little or no dividends to stockholders, instead they put most or all of their profits back into the company for expansion. It can be investing in current products or reinvesting in new profitable opportunities.
  • company has business in a large and expanding market.
  • company has a good competitive advantage over others.
  • company has a talented leadership with skin in the game and great corporate culture.

Main focus of these companies is to maintain industry leadership.

Why investors choose growth investing

Investors based on their time horizon and appetite for risk decide whether to go for growth investing or not. In general, young investors with long term horizon and higher tolerance of risk go for growth investing.

This means, an investor looking to invest a portion of the portfolio for a very long term period can adopt growth investing strategy. These companies use every resources to expand their products or services to generate more revenue and dominate their market.

Imagine you have the following two choices of investing in two different types of stocks;

  • Stock of company A which has a very good dividend yield and dividend payout ratio.
  • Stock of company B which has a lower dividend payout ratio and dividend yield. However, company B is growing at a rate of 25% year on year with a very good portfolio of products or services. Total retained earnings of company B is invested in new and existing products.

If you follow growth investing strategy, you probably invest in stock B to have more return in the future as the company is reinvesting its earnings instead of paying dividends. However, if you follow dividend investing strategy, then you might prefer stock A.

In general, you will find these companies with high price to earnings ratio and price to book value ratios as market is certain about these company’s growth potential.

In growth stock,there can be a point at which the core business may reach its full potential with less opportunities and acquisition. In such a case, the management may decide to distribute the surplus money to shareholders in the form of dividend or prefer share buyback. As an investor, you can diversify your portfolio by investing in value and growth stock. You can also add some dividend paying stocks based on your strategy.

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