Growth Stocks

What Are Growth Stocks?

Growth stocks, as the name implies, are shares in any company that is anticipated to grow at a rate significantly higher than the market average. These stocks usually do not pay dividends because such companies reinvest any accrued earnings to accelerate short-term growth. Though some growth companies may not be immediately profitable, investors select them on the anticipation of future earnings growth that will lead to share price appreciation.

As such, growth stocks often look expensive and trade at a high price-earnings (P/E) ratio. These valuations may end up being cheap or worthwhile if the company continues its rapid growth. However, since much of the share price is based on future prospects rather than realized earnings, growth stocks can see dramatic declines if the companies fail to meet those lofty expectations.

Growth stock examples include Facebook, Amazon and Netflix. Many associate large tech stocks with growth investments because they trade at high price-earnings ratios and anticipate large future earnings even while currently losing money or making only a small profit.

How Can I Find Growth Stocks?

Investors can identify growth stocks by a few factors. Growth companies tend to have substantial room for capital appreciation, trade at high price-earnings ratios, tend to be newer (they may have recently gone public through an initial public offering, or IPO) and are generally smaller-cap companies or those in traditional growth sectors such as technology and biotech.

Hypergrowth Stocks

Hypergrowth stocks are a subset of growth stocks whose underlying business is growing at a high-double-digit to triple-digit pace. Predictably, hypergrowth stocks trade at even higher price-earnings ratios and have higher ambitions still, which can make them riskier than regular growth stocks if company performance declines. Of course, the opposite is true: Torrid price appreciation can continue if the company meets or exceeds its expectations.

Growth Versus Value Stocks

Importantly, growth stocks and value stocks differ significantly. They have different identifying factors and expectations among those who invest in them. Contrary to growth stocks, value stocks tend to trade at a low price-earnings ratio. They’re often underrated or ignored by the market. Because of their beatdown value and tendency to be overlooked, if such companies experience earnings surprises or start to grow at fast rates, their stock often rebounds at a significant clip.

Since value stocks have low expectations, a quarter or two of disappointing results often does not significantly burden the share price, as it would for growth stocks. These companies may also pay dividends, giving patient investors a steady stream of income as they wait for capital gains.

Is Growth Investing Right for Me?

Selecting an investment strategy depends on a few individual factors, namely your risk tolerance and investing time frame. Growth investing necessarily entails risks—primarily, the risk of price collapse following disappointing earnings. However, investors with long time horizons and an aggressive risk allocation have time to weather such downturns and reinvest their capital into other stocks whose gains may offset losses.

A contrasting strategy is the relative safety of dividend stocks. Dividend stocks, compared with growth stocks, experience lower price volatility, with quarterly payouts protecting against downside price drops. Generally, dividend stocks also have lower upside potential as earnings get distributed to shareholders rather than reinvested in the company to fuel additional growth.

Which strategy you pursue depends on whether you value the potential for strong capital gains or would prefer the relative security of predictable income from your portfolio.

For investors who want to invest in growth stocks but don’t want to go through the time-consuming exercise of identifying such companies by pouring through financial statements and studying stock performance, growth stock mutual funds or growth stock exchange-traded funds (ETFs) provide easy investment opportunities. These securities bundle invested dollars and purchase an index or “basket” of individual growth stocks. Investors in the mutual fund or ETF benefit when those held securities appreciate in price.

As mentioned, investing in high growth stocks can be risky. The high reward for future growth is coupled with a high risk for rapid price decreases when a company fails to live up to the expectations set by its investors. Such fluctuations can also increase the volatility of the stock, potentially making them less attractive investments for those in or nearing retirement. Growth stocks also don’t always outperform the market. They tend to do well during bull markets or periods of expansion, whereas value stocks tend to outperform during bear markets and recessions.

Conclusion

Growth stocks are securities with expectations for market-beating earnings growth and performance. They can dramatically outperform the market if the company lives up to expectations; conversely, failure to meet such anticipation can decimate its share price. Unlike value stocks, growth stocks trade at high price-earnings ratios and typically command a lot of attention. Whereas dividend stocks offer consistent income, growth stocks generally do not pay dividends. Deciding whether such an approach is right for you depends on your risk tolerance, time frame and goals.

AAII can help you identify all of those so you can construct the appropriate portfolio to achieve your financial goals. We also offer tools and screens to provide you with growth stock ideas, updated daily, and proprietary A–F stock grades for your own research.

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