The growth investing strategy is very similar to the value investing strategy. The main difference is that growth investing places an even heavier focus on qualitative factors. Growth investors still look at quantitative factors, but they will place a larger emphasis on other factors such as management and product quality. Growth investors are also more open to risk.
Growth investing began with the ideas of Phil Fisher. He put down the fundamental definition of a growth stock: a relatively small company with new management or operating in a new industry, generally evaluated by talking to people who are very knowledgeable about the company’s industry.
These ideas were later expanded on by famous investors such as Warren Buffett and Peter Lynch. They added new places to find growth stocks and more comprehensive ways to evaluate those stocks. But one important aspect of growth stocks has never changed: It is all about the story, and it is all about the future.
i. Where to Find Growth Stocks
There are a few ways to find a growth stock. One common way is to look for what are called special situations (this will be covered in another section). Other common ways to find growth stocks include looking for a cyclical company that is at the end of a down cycle, companies that compete in brand new industries, or companies that dominate a small industry.
A growth stock is not the same thing as a growth industry. You can find growth stocks in any type of industry. You are more likely to find growth stocks in growth industries, but the growth stocks in other types of industries are usually more predictable. For example, Peter Lynch says that the typical growth company will not easily catch your attention. It will have a boring name and operate in a boring industry (such as Waste Management in trash hauling).
According to Lynch, the very best growth companies are rarely followed by Wall Street analysts (1 or 2 analysts at most) and have low levels of institutional ownership (meaning very few mutual funds own shares in the company). Searching for institutional ownership of less than 25% is one possible way to find potential growth stocks, but talking to competitors and customers in the industry will often give you the best idea of which stocks are good candidates for growth.
ii. What to Look for in a Growth Stock
What you look for in a growth stock depends on the amount of growth you are looking for. Phil Fisher’s idea of a growth company was relatively conservative. He came up with a checklist of 15 points for evaluating a growth company. Most of this information can be found by reading the company’s annual reports:
1. Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?
2. Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?
3. How effective are the company's research and development efforts in relation to its size?
4. Does the company have an above-average sales organization?
5. Does the company have a worthwhile profit margin?
6. What is the company doing to maintain or improve profit margins?
7. Does the company have outstanding labor and personnel relations?
8. Does the company have outstanding executive relations?
9. Does the company have a depth to its management?
10. How good are the company's cost analysis and accounting controls?
11. Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition?
12. Does the company have a short-range or long-range outlook in regard to profits?
13. In the foreseeable future will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders' benefit from this anticipated growth?
14. Does management talk freely to investors about its affairs when things are going well but "clam up" when troubles and disappointments occur?
15. Does the company have a management of unquestionable integrity?
Fisher’s evaluation is timeless, but many investors feel that most of the points on his checklist relate more to value companies than growth companies. For fast-growing companies, modern investors use Peter Lynch’s condensed version of this checklist:
1. Small aggressive companies growing their earnings at 20% to 25% a year.
2. A proven growth formula that can be used in other locations.
3. A healthy balance sheet with healthy profit margins and high ROE.
4. A simple business that anyone can run, operating in a boring industry.
5. a P/E ratio that is at or near the growth ratio (For example, if growth is 20%, then P/E should be around 20).
iii. When to Buy a Growth Stock
Growth stocks are all about earnings growth, so you will ideally buy the stock before its earnings take off, and sell it when that growth begins to decline. This can be difficult because sometimes a cyclical stock near the top of its cycle can be mistaken for a true growth stock. You will want to know the difference.
For some growth stocks, the best time to buy is just as R&D investments begin to pay off with the introduction of a successful new product. Investors using this strategy probably would have considered investing in Apple after it developed the iPod, iPhone, or iPad.
Many growth investors also get caught up in trying to get the best deal possible. Usually, this means waiting until the price has dropped “enough” to justify buying. Sometimes they will also get discouraged when the price jumps or the P/E ratio rises (a high P/E is not bad if it is justified by a conservative estimate of future growth). This hurts the growth strategy because focusing on the price movements distracts from evaluating the future of the business.
Like value stocks, you should buy when your expected value for the company is significantly higher than its current price. The price is what you pay, but the value is what you get.
iv. Caution for Growth Investors
It is very important to understand the difference between a true growth stock and what Peter Lynch calls a “whisper stock.” A whisper stock is a hot stock that everyone is talking about. It is a stock that is only considered a good investment because the crowd calls it a growth stock. A true growth stock will show its potential in your evaluation, and not by whether people say it is a good growth stock investment.
Sometimes the optimism about a company’s future comes straight from the company’s managers. Your evaluation also shouldn’t be based on how the managers feel about their own company’s future (it will always be positive). You can find better information by talking to their competitors and their customers.
v. Growth Investing Mindset
Growth investors use most of the same tools that value investors use. Both are considered long-term fundamental investment strategies. But the growth investing style puts a much greater emphasis on the company’s expected future performance. The best investors use a combination of both strategies.
The main focus for growth investing is buying great companies at fair prices, instead of buying fair companies at great prices. Paying a fair price is riskier than buying cheap, but the quality of the company’s business should make up the difference.
The best growth investors understand that stability and growth are never guaranteed. Not every investment will live up to your expectations, and there is nothing wrong with that. If you have ten growth investments, and only one of them performs the way you expected, then you should still do very well. If your analysis is good, then the big winners will outweigh the big losers.
Some of the best growth stocks are not traded on any of the main stock exchanges. If you see that the company you are evaluating is traded over-the-counter (OTC), that doesn’t automatically mean it’s a bad investment. It just means that you need to be more careful about the numbers that the company reports.
Deciding when to sell can also be difficult. It is tempting to sell just because the price has gone up or because you fear that it will go down. If you find yourself wanting to sell, re-evaluate the company as if you were looking at a potential buying opportunity. If you find that the value is still significantly better than the price, don’t sell. If you see that the company’s prospects have changed for the worse, then you should consider selling.