What Are Growth Stocks?

Growth companies are projected to have a faster growth rate than their competitors in the market. As a result, shares of growth companies are also expected to rise in value faster compared to their peers. 

Growth stocks typically have a higher price to earnings (P/E) ratio, which means that they are overvalued. The reason for this is that investors who buy these stocks take into account the faster growth rate these companies have. These stocks also offer higher returns to investors.

Traders investing in growth stocks expect them to surge in value at a fast pace. This is a typical case for new stocks within emerging industries that do not pay dividends but rather focus on reinvesting their profits to fuel further expansion.

Most of the stocks that have smaller market capitalization are viewed as growth stocks, though large companies can sometimes be considered growth stocks as well, especially in the tech sector.

Key Characteristics of Growth Stocks

As already explained, growth stocks tend to show a significantly higher growth rate than the average market growth rate. 

A key characteristic of growth stocks is that they have a high P/E (price-to-earnings) ratio. Many growth companies are usually only profitable a couple of years after they go public.

Additionally, growth companies are known for paying zero or no dividends. The reason for this is that these companies are focused on reinvesting their earned capital and driving revenues further.

Another characteristic of growth companies is that they typically offer unique advantages to their consumers, making them stand out from the competition and hence more appealing to investors. Thanks to these advantages, growth companies have a unique selling proposition.

Because of the unique selling proposition and other competitive benefits, growth companies see their consumer base grow at a strong, constant pace, additionally boosting their growth rate.

Investors who buy growth stocks do not expect strong near-term returns given that these companies pay zero or no dividends at all. On the other hand, growth companies offer significantly better long-term prospects, allowing investors to yield robust returns through capital gains as these companies typically record considerable growth over a multi-year period. 

Another characteristic of growth stocks is that they tend to have very volatile reactions to positive or negative catalysts. For instance, a deterioration in the geopolitical situation is likely to push growth (more expensive) stocks much lower as investors tend to focus on more secure investments, like defensive stocks, bonds, gold, or safe-haven currencies (Swiss franc, Japanese yen, or the US dollar).  

What are the Pros of Investing in Growth Stocks?

One of the main benefits that growth stocks offer to investors is the previously mentioned competitive advantage they have in the market. This advantage can refer to a proprietary technology the company develops or another innovative solution that makes the company stand out in its respective industry. 

These unique advantages and solutions allow growth companies to have a more faithful, faster-growing consumer base than their rivals. At the same time, growth companies that develop innovative solutions are likely to gain a large market share, particularly if they are developing a completely new product or service. 

On the other hand, if companies compete in the market with a similar product, only those with strong and loyal consumer bases are likely to become growth companies.

As mentioned above, arguably the greatest advantage of growth stocks is that they offer higher-than-average returns to long-term investors. 

What are the Cons of Investing in Growth Stocks?

Investors who are inclined to buy growth stocks should factor in certain risks they bring. While growth stocks can yield robust profits to investors, they also carry a high degree of risk and uncertainty. This is especially the case in times of market turmoil and geopolitical challenges when investors seek shelter from higher market volatility. 

Another risk factor that should be considered is that growth companies do not pay dividends, meaning that the only way investors can capitalize is to sell shares at a higher price than that at which they bought the stock. However, if these companies do not fulfill their potential and eventually disappoint, investors are likely to sustain losses when selling the stock.

Paying low or no dividends also suggests that investors should focus more on long-term outlook when buying growth stocks because odds for turning a profit in the short run are not as good due to higher uncertainty. 

The difference between Value and Growth Stocks

Investing in value and growth stocks has its own pros and cons. As mentioned above, investors who buy growth stocks typically expect to see strong profits as these companies offer a significantly higher return potential. 

Contrarily, value stocks have a considerably smaller growth rate but they normally pay dividends to investors. Even though they have a lower P/E ratio, value stocks can also rise in value.

Consequently, there is no perfect choice for investors. This is why some investors prefer to diversify their portfolios by investing in both growth and value stocks, while others like to focus on only one of them. 

Stocks that are trading below their intrinsic value are generally viewed as good investment opportunities. Legendary investors like Warren Buffet and Benjamin Graham are best known for their ability to detect such opportunities and see massive capital returns once these stocks fulfill their potential.

Value investing requires a more conservative, long-term approach. It is very difficult to secure positive returns in the short-term with value investing as some investment opportunities require a lot of time before they return trading at or above their intrinsic value. 

On the other hand, growth investing is also attractive for investors with a more short-term approach. For instance, a growth investor can back one tech-focused software company that is likely to produce robust near-term results and therefore, see its stock price explode.

As opposed to growth stocks, value stocks typically have a low P/E ratio and low price to book value (PBV) ratios but they offer investors decent dividend yield. While growth stocks usually operate in fast-developing industries, value stocks can be found in industries that have a significantly slower growth pace e.g. defense, food, healthcare, etc.

Growth Stock Example

A majority of growth stocks today belong to the tech sector. There are many innovative, fast-growing companies that are offering both high returns and high-risk to investors today. One of these companies is Netflix, a streaming giant that grew massively in popularity amid the COVID-19 pandemic outbreak.

Netflix stock price rose over 140% in the period March 2020 – November 2021. This is a higher growth rate than the S&P 500 that grew 116% during the same period. However, from November 2021 to March this year, Netflix stock price fell 53%. On the other hand, the benchmark US index S&P 500 fell just over 13%.

The Netflix case demonstrates both the pros and cons of investing in growth stocks:  higher-than-average returns in the bull market, but also greater-than-average losses when the market turns red.

The fundamental aspect of the Netflix story also shows us why investors are attracted by growth stocks. In 2018, Netflix generated revenues of $15.8 billion, followed by $20.1 billion, $25 billion, and $29.7 billion in 2019, 2020, and 2021, respectively. 

This way, the streaming giant was able to generate above-average annual revenue figures for at least 3 consecutive years. Netflix’s profitability numbers paint a similar picture. EBIT (earnings before interest and tax) was $1.64 billion in 2018 before jumping to as much as $6.6 billion in 2021.

As said earlier, growth stocks tend to have a high P/E ratio, which practically means they are expensive relative to some other stocks. Netflix, for instance, has a current P/E ratio of 33.87, which is higher than the P/E ratio for S&P 500 of 24.56.

Similarly, Netflix is not paying dividends yet as it is focused on reinvesting profits to grow its business and expand internationally. However, investors are attracted by Netflix’s strong growth rate and expectations that the company’s business model is robust enough to continue producing an above-average revenue growth rate.

Conclusion

Growth companies are growing at a higher-than-average rate and usually operate in the tech industry. Some of the key characteristics of growth stocks are that they offer high returns but also come with a high degree of risk. These stocks tend to be expensive as their P/E ratio is usually very high.

However, investors are betting that these companies can return strong profits in the long run despite the fact that their current profitability may be either non-existent or very low. This is why growth stocks represent a more attractive part of the stock market as they tend to return high profits to investors. 

Growth investing is opposite to value investing, which is focused on identifying stocks that trade below their intrinsic value in order to secure massive capital returns once these companies are able to fulfill their potential.

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