What Are Growth Stocks?

By Tim Lemke on 6 October 2016 0 comments

Growth. It's what you want if you're an investor, especially if you're many years away from retirement.

Any investment portfolio should have a heavy dose of stocks that offer strong returns over time, from companies with solid earnings records. These are growth stocks. But what exactly is a "growth" stock? What are its characteristics, and how does it differ from other kinds of investments? And what are some ways to invest in them?

Here are nine things you need to know about growth stocks and their ability to supercharge your portfolio.

1. It's All About Earnings

When seeking out quality growth stocks, it's key to look for the company's track record of earnings that are above the market average. The best companies will have reported consistent earnings growth quarter after quarter and year after year. A track record of five years in a row of growth is usually a good barometer, according to guidelines offered by Investor's Business Daily.

2. They Often Don't Pay a Dividend

When you buy growth stocks, you want to see the share price rise and don't care much about income. And that's good, because growth stocks generally don't pay out dividends to investors. Instead, these companies take whatever net earnings they have and reinvest them in research, new products, new business lines, infrastructure, and acquisitions. In other words, their cash is being used to make the company bigger.

3. They Are Often Smaller Companies

Many growth stocks fall into the category known as "small cap," which is shorthand for saying a company has a small market capitalization (usually less than $2 billion). This small size means that there's the potential for quick growth. Smaller companies are often aggressively investing money back into the company to boost earnings and grow.

4. They Are Often Younger Companies

Generally speaking, the more established a company, the less likely they are to see supercharged growth on a quarterly basis. In fact, most companies see their fastest growth in the first decade after going public. Consider that Facebook has seen shares rise sevenfold since the summer after going public in 2012.

5. Their Stock Prices Don't Always Make Sense

For many growth stocks, share prices aren't always a reflection of the company's current value. Rather, their share price is based on what investors think a company may be worth in the future. In other words, the growth is often "baked" into the stock price already. Often, a growth stock will seem overpriced based on its price to earnings ratio. But with many growth stocks, the price to earnings ratio does not have much bearing on a company's price. In fact, many of the stock market's biggest success stories, including Apple and Amazon, have seen big run-ups even when price-to-earnings ratios were high.

6. Growth Comes With Risk

If you want growth, you're going to have to be comfortable with losing money once in awhile as well. Growth stocks tend to be more volatile than the broader market. In essence, the potential for growth is your reward for accepting some additional risk. That's why growth stocks aren't the best investments for someone who is close to retirement age.

7. You Can Buy Funds of Growth Stocks

If you're not sure which growth stocks to buy, there are mutual funds that have you covered. Most major brokerage firms offer the ability to invest in a wide range of stocks that are younger and growing more quickly than the rest of the market. Like the stocks within them, growth stock funds can be volatile, but rewarding for a patient investor. Top examples include the Vanguard U.S. Growth Portfolio and the Fidelity Growth Strategy Fund. There are also exchange-traded funds, such as the iShares Growth Core Portfolio Builder, which are often available to trade without a commission.

One caveat is that there are often a plethora of confusing choices, including small-cap, large-cap, and mid-cap growth funds, and growth funds focused on specific industries. It's fine to own more than one of these funds, but it's best to research these funds first to ensure there is no overlap in the companies you are invested in.

8. They Are Not to Be Confused With Value Stocks

We often hear growth and value stocks mentioned together because they both offer great opportunities for investors to make money. But value stocks differ from growth stocks in that they are considered to be undervalued by the market, and thus offer a potential bargain for investors. Growth stocks are often overvalued and less of a bargain for investors, but have a stronger track record of earnings. Most financial advisers recommend holding a mix of growth and value stocks in your portfolio.

9. Look for Leaders and Innovators

Typically, the best growth stocks are those from companies that are leaders in their industries, and who have shown a penchant for innovation. Consider a company like Starbucks [NASDAQ: SBUX], which is synonymous with coffee. Apple, Amazon, and Facebook are examples of solid industry leaders and great growth stocks. But it's also worth looking at fast-growing companies that aren't yet their industry leader. Under Armour [NYSE: UA] is one example of a company that isn't yet #1 but has seen better-than-average earnings and share growth in recent years.

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