Growth Investing Definition
Growth Investing refers to capital allocation in potentially high earning companies such as small caps, startups etc. that grow much faster than the overall industry or mature companies. As the returns in such investment is high, the risk faced by such investors is higher too.
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Source: Growth Investing (wallstreetmojo.com)
Examples of Growth Investing
Example #1
Portfolio A and Portfolio B consist of four stocks each. At the same time, portfolio A has given a return of ~28% and portfolio B has generated a return of ~7.5% during the bull marketBull MarketA bull market occurs when many stock prices rise 20% from a recent low for an extended period. In addition, it is expected that prices will continue to go up. The bullish phase marks an increase in investor's confidence, corporate profits, reduced unemployment, and an improving GDP.read more scenario. Portfolio A consists of blue chips and growth stocks, while portfolio B consists of defensive stocksDefensive StocksA Defensive Stock is a stock that provides steady growth and earnings to the investors in the form of dividends irrespective of the state of the economy as it has a low correlation with the overall stock market/economy and is therefore insulated from changing business cycles.read more, whose profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance.read more grows less than the GDP.
The index has generated a return of 13.5% during the time span. Thus, we may conclude that during good times portfolio A will surpass the index return during a good bull market, while defensive stocks will generate a return which is less than the index.
Example #2
During the recession, we have seen that the price to earnings metrics tends to erode, irrespective of the quality of the stocks because of the negative investor’s sentiment. Thus, richly valued blue-chip stocks become cheaper because the market will discount the overall sentiment and will drive the price lower. On the other hand, slow growers or defensive categories tend to remain in the same range.
The reason is that irrespective of the market conditions, the price to earningsPrice To EarningsThe price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share. read more multiples or other valuations metrics remains low for these categories of stocks. So, during economic recessionsEconomic RecessionsEconomic recession is when economic activity is stagnant, and there is contraction in the business cycle, over-supply of goods compared to its demand, and a higher unemployment rate resulting in lower household savings and lower expense, inflation, higher interest rate and economic crisis due to higher fiscal deficit.read more or slowdown, these slow growers resist the drawdown of the portfolio.
Advantages
- Growth Investing includes stocks that have the potential to provide high returns to investors. The potential of stock price movement is directly correlated with the profitability growth of the company. The higher the growth, the higher is the return.
- As the return is high, the risk to reward ratioRisk To Reward RatioThe risk-reward ratio is the measure used by the investors during the trading for knowing their potential loss to the potential profit. Hence it is used by the traders for effectively managing their risk and capital during the trading process.read more, as well as return on investment (ROI) remains on the higher side.
- Capital appreciation is one of the primary aspects of growth Investment. Unlike other Investment methodologies, the return from this particular segment is the maximum as the primary focus remains on blue-chip, growth companies, stalwart or market leader categories and not on the defensive stocks.
Disadvantages
- In the growth investing approach, the fund managers concentrate on the future growth of the businesses and give the least focus on the valuation of the stocks like preference on the price to earnings, Enterprise value to EBITDAEnterprise Value To EBITDAEV to EBITDA is the ratio between enterprise value and earnings before interest, taxes, depreciation, and amortization that helps the investor in the valuation of the company at a very subtle level by allowing the investor to compare a specific company to the peer company in the industry as a whole, or other comparative industries.read more or price to bookPrice To BookPrice to Book Value Ratio or P/B Ratio helps to identify stock opportunities in Financial companies, especially banks, and is used with other valuation tools like PE Ratio, PCF, EV/EBITDA. Price to Book Value Ratio = Price Per Share / Book Value Per Share read more of the stocks.
- In most of the cases, the focus becomes on the blue-chip, stalwart or market leader or various small-cap or midcap categories where the valuation is on the higher side.
- The risk is comparatively high as compared to the other conventional approaches used in investing.
- The margin of safety is comparatively low in Growth investing because funds are diverted towards growth companies that fall in the small-cap and mid-cap categories stocksMid-cap Categories StocksMid-Cap stocks are the stocks of the companies having medium market capitalization. Their capital lies between that of large and small cap companies and valuation of the entire share holdings of these companies range between $2 billion to $8 billion.read more. Due to the changing business scenarios, the profitability from these companies becomes volatile and impacts adversely on the stock prices.
- During the time of economic recession, this particular approach does not help to retain the actual invested capitalInvested CapitalCapital Investment refers to any investments made into the business with the objective of enhancing the operations. It could be long term acquisition by the business such as real estates, machinery, industries, etc.read more.
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This has been a guide to what is Growth Investing and its definition. Here we discuss the various components of growth investing stocks along with the examples. You can learn more from the following articles –
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