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Growth investing

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Growth investing is about putting your money into companies you think will make greater profits in the future. It is usually considered the flip-side of value investing.

Most viable listed companies will grow profits over time, so a growth investor is looking for companies that are expanding their profits faster than rivals or the market.

Growth investors aim to make capital gains from a higher share price, as opposed to for example buying dividend paying shares for income.

The very best growth stocks can deliver returns of a hundredfold or more after decades of growth, although by definition only a tiny handful of the thousands of companies listed will ever reach blue chip status.

Most growth shares fizzle out long before they trouble the top of the index:

  • Sometimes a growth company slows down to become just another staid performer (also known as going ‘ex-growth’). This outcome can still make you excellent returns if you got into the share early enough.
  • Other would-be growth companies die trying.
  • My personal bugbear is when growth companies are acquired when still young and with all their potential ahead of them. This happens quite often; if you can see the potential in a company, so can industry rivals.

Even when a growth share does go all the way from small cap growth stock to international giant, few investors stay aboard for the entire ride. Owning a successful growth share is a dizzying experience!

Growth investing is hard. Much more common than finding a Microsoft is buying a ‘jam tomorrow’ share, that promises much but never delivers.

This reached its zenith in the Dotcom boom, when companies were growing sales or market share but weren’t growing profits, or even making any money at all.

While all growth investors will inevitably put more emphasis on the business story and the potential for expansion than a value investor, sensible growth investors look at cashflow and return on capital employed to see how the company is multiplying their investment.

Finally, it’s worth noting that some investment greats like Warren Buffett and Peter Lynch argue it’s a mistake to think in terms of value or growth shares.

Buffett espouses the idea of ‘intrinsic value’ instead.

However as a convenient way of labelling an investing method that focusses on profit growth as opposed to value investing’s emphasis on under-rated assets or performance, the growth investing label is useful and here to stay.

Filed under: Financial glossary

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{ 8 comments… add one and remember nothing here is personal advice }
  • 1 Robert Price May 23, 2013, 9:58 am

    Would companies such as ARM Holdings or Tesla count as growth or ex-growth. As both companies are small (compared to competition) who have lots of potential future growth, but have already had big bursts of growth – so less potential for future growth at same rate?

  • 2 The Shoestring Investor May 23, 2013, 2:15 pm

    In my opinion, while it’s nice if you can find the right company and get a genuine growth share, the chances are small and it’s much more likely you’ll be worse off than if you were to just invest in more risk averse ways.

    This article is a good balanced look at it, but to me it’s not huge distance from “£100 on black” as a means of investment.

  • 3 Greg May 23, 2013, 7:14 pm

    I think the problem with growthy shares is that it is factored into the P/E. Therefore, if they report bad results then not only do you take the hit from the results themselves, but the P/E could fall too if the assumed growth isn’t there. This cold be a significant double whammy…

  • 4 KL May 23, 2013, 10:22 pm

    As you mentioned Peter Lynch, just wanted to point out an inconsistency I’ve spotted regarding his whole brand. He’s knows for i) outperforming the S&P500 ii) for holding about 1500 stocks in his portfolio.

    Clearly 1500 > 500, he wasn’t picking shares from his benchmark’s universe, and if I were a betting man I’d bet that much of his outperformance can be explained by portfolio theory rather than stockpicking. He was picking from a wider universe of riskier shares during one of the strongest bull markets in history.

    Don’t want to come up as cynical, I’m just very sceptical on claims of consistent outperformance by managers. That being said I like his books, have them all in hardcopy, kindle & audiobooks.

    Bring on the growth investing series, all your investing articles rock – keep it up!

  • 5 The Investor May 25, 2013, 5:12 pm

    @Robert — They are both growth shares, I think. Tesla has a multiple in the stratosphere that will only be justified if it keeps growing at a good double digit rates for years. (I am betting it will, incidentally, and have a very small holding from around $30). ARM is still rated as a growth share, but I always fear things are as good as they will get for ARM (only to be proven wrong). Holding a growth share that goes ex-growth is a painful experience. (I’m overwhelming a value / special situation investor with my direct stock picks, but I do dabble in growth and I have seen this happen first hand. The de-rating can be brutal).

    @Shoestring Investor — Well, it’s certainly a lot more complicated than “bet on black” but statistically the odds might work out the same! I know a couple of very successful growth investors (easily beating the market over 10 year periods) but they do apply a very particular technique, which is quite different from most investing and where it’s very easy to conclude instead that luck has outweighed skill. (For instance, growth investors usually owe a huge slew of their results to the few outrageous winners that they had the fortune (/skill?) to alight upon and the unusual fortitude to keep holding.

    I have a very small allocation to exciting growth shares in my active portfolio, and strict rules these days about how much money I can put in to any one. I could never be anything like a true/pure growth investor.

    @Greg — Absolutely, the dreaded de-rating! I am more a fan of GARP shares where you may get a rating the other way. (So what seems a P/E 10 sort of share overdelivers and as well as earnings growth you get a re-rating to P/E 15. This is the essence of the Jim Slater Zulu method, incidentally).

    @KL — Interesting comments and thoughts. Personally I am pretty non-plussed by academics insisting that anything you do to not look like an index is somehow ‘cheating’ (such as holding a lot more / a lot smaller companies) or explained by their risk/return models, but I haven’t got the academic chops to explain myself well. (Search this site for articles on Risk in investment if you want more, or see my comments on the attempt last year to Debunk Buffett by applying fully half-a-dozen ‘explanations’ to his results.

    Glad you like the topic though (and Lynch! I think he’s great and inspiring, even if all active investing ultimately is a chimera). If you click on the ‘Growth Investors’ link a few paragraphs down in this article above, you’ll find a fully recap of my thoughts on growth investing methods, though I’ve developed my thinking a little more since then.

    On managers beating markets, from memory a lot do beat the market, I think a few per cent more than 50%, and over long periods. (Presumably by taking profits from ‘dumb money’, private investors, similar). The problem is fees and charges and hidden costs, that then gobble up this excess return to leave them doing worse overall then if you’d just used a tracker, in aggregate.

    It’s charges (and the fact you don’t need to beat the market to get the results you need) that mean most people are best off in trackers then punting on a basket of fund managers, IMHO.

    This is one reason why I actively invest some of my money myself, as opposed to putting some of it into active funds, incidentally. Besides the main reasons (challenge, enjoyment, ego) I don’t charge myself a wage! My TER on my total portfolio so far this year is 0.55% or thereabouts to date. It’ll likely come in at about 1% by year end. I’d rather have the fun then pay a manager to spend my 1%.

  • 6 KL May 26, 2013, 12:26 pm

    Re Lynch, you agree though that in order to claim outperformance he shouldn’t be doing it vs the S&P500 ?

    the way I view it with managers is this. They are the market, so in a given year by definition about 50% of them will outperform and 50% will underperform. take fees t-costs from their performance and most will not beat an index.

    I pick shares , because I enjoy it, but the truth is that the driving force of my stocks performance is market beta. Even if I outperform slightly, you have to factor in the work hours I put vs pressing click to buy an index fund, so work hours+ outperformance won’t beat index investing + getting payed to work for these hours !

    I choose stocks because I enjoy the process and because I may want to be on a different subsegment of the index eg. because I may prefer a stream of income for my SIPP ( if the flexible drawdown option still exists when I retire ! ) or because I may fancy taking a punt if I like a growth story.

    That being said of course there are managers that have outperformed for long periods of time, both here and in the US. Still, their strategy at some point leaks a bit and alternative indices are created.

    Another thing to factor when comparing these managers vs individuals is that they eg have non margined leverage sometimes and this alone can help outperforming the index and other tools at hand which aren’t available to the retail investor.

    I also try to time the market from time to time – I’m more of an active investor overall – but I think 99% of people would be better off with passive investing in terms of payoff.

    Still for those of us who like the process of picking stocks, read research reports, track the financial news daily and like to dig down to ratios & statements, it’s too much fun to just pass – I don’t think the index outperformance would be significant though in the long run, if you factor in the extra hours of work though !

  • 7 The Investor May 28, 2013, 12:17 pm

    @KL — I think we agree more than we disagree. 🙂 We agree that fund managers in aggregate will underperform, if only due to costs, and that the best reason to pick shares yourself is because you enjoy the process. We also agree that most people should be in passive funds (probably all, but for some such as us the “fun dividend” is worth the risk of doing worse).

    Where I am a bit heretical is I don’t get hung up on these “pick the right index” issues that fund manager critics invariably bring to the fore.

    Obviously I respect that complaint/argument, and well understand that if person X is picking 1500 stocks and person Y 500, then person X has a different opportunity set. Given that we know in particular small caps will outperform, person X could do better simply on account of exploiting this risk premium.

    However I think the fact is Lynch chose to own 1,500 stocks, not say 200. That’s a choice he made (versus say Buffett, who is much more concentrated).

    He also was chosen by investors who might otherwise have invested broadly in the S&P for *similar* exposure. Savvy Monevator readers might decide to hold the S&P 500 at 80% weighting and 20% in some cheap small cap ETF but the average person would be looking to big brand name active funds or passive funds, and those very likely choosing between Lynch or one of those rivals. So it’s a valid comparison in that respect.

    Finally, I have had these torturous index/benchmark conversations many times before, and they tend to involve endless “yes buts” whereby the comparator benchmarket is continually changed until it seems to almost mimic the actual portfolio being looked at. And then they want to risk-adjust it to get rid of any residual outperformance.

    I think all this is pretty poisonous to having any chance of beating the market (in fact, I think this sort of thinking is one reason why so many active funds have become index huggers, with no chance of justifying their fees) so personally I don’t go too far down that road myself, especially as I don’t really respect the academic underpinnings of risk and the EMH to the very nth degree.

    Bottom Line: I think your complaint against the S&P as a benchmark for Lynch is absolutely valid, and is the sort of thing that we should always think about when looking at any investment record. But personally, I don’t think the benchmark is a bad/unjust/hideously misleading one.

  • 8 thepotatohead June 1, 2013, 6:10 pm

    It’s often exciting to pick growth companies with dreams of huge return on huge growth. These dreams often don’t play out how you expected though, as growth companies aren’t nearly as established and can run into bad times easier. SO be careful when choosing what stocks you want to invest in on the growth side.

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