A growth stock is stock in a company that is growing rapidly. This is typically a young company that only has a handful of business lines, a lot of investment in research and development, and a presence in only a few markets. Often growth stocks pay no dividend since they need all of their available cash to fund investment and growth.
An investor buying a growth company would be expecting to make money from the purchase primarily in the form of capital gains, i.e., selling the shares of the company for a higher price. This is a less certain way to generate an income than receiving a dividend, so buying growth stocks is more risky than buying income stocks. The potential reward, however, is much greater since growth stocks may return 50-100% or more in some years, with long-term rates of return in the 15-30% range, while income stocks may return 6% or less. The return of individual growth stock will vary greatly, however, with some companies failing and perhaps going out of business.
The easiest way to recognize a growth stock is from the price chart. A good growth stock will have a price that increases at a fairly steady rate over several years. Earnings, revenues, and book value will also be increasing as the company grows and generates more money. Such a stock is said to have momentum, in that the price is increasing and will tend to keep increasing. Momentum investing and growth stocks therefore go hand-in-hand.
Growth stocks also tend to have higher Price to Earning (PE) ratios than more mature companies because they are growing rapidly. People tend to pay more for current earnings with a growth stock than they would for a company with stable earnings since they expect earnings to be higher in the future. The amount of risk factors into the price as well, however, with the PE ratio declining as risk increases. This is because the potential reward must be greater if earnings are uncertain to make up for the risk being taken.
Holders of growth stocks should be like the companies themselves – young with a lot of time ahead of them, and therefore with the ability to take some risks for a potentially outsized reward. This isn’t to say that people in their late working careers or even in retirement shouldn’t have growth stocks in their portfolios. It is just that the percentage of growth stocks should decline as your time horizon decreases. The larger your portfolio, however, the more risk you can take. Someone with $1 M who was counting on the portfolio for income would be in bad shape if their portfolio declined by 50%. Someone with $10 M could take a 50% loss and still have plenty of cash available for living expenses.
Some of my favorite growth stocks are in the retail and restaurant businesses. These types of businesses are able to grow by simply adding new stores or locations. Their ability to grow is also fairly easy to assess by seeing which regions of the country and perhaps the world they have yet into which to expand.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.