Why growth investing is important for you
Where do you put your savings? Due to inflation, a traditional savings account might not be a suitable place, so an alternative is required.
The common stock market offers a great way to invest your money. This leads to the following question:
Say you have 10k of savings today which you want to invest. Which company / companies should you choose to have maximal yield within a decade?
For the last 10 years, Google was a very wise investment choice. If you invested $10k in Google stock a decade ago, you would have close to $100k today.
So how do you find the Google of the next decade? This is exactly what growth investing is all about: this strategy states that a prolonged growth phase of a company will lead to a beautiful rise in share value.
In this article, I will explain the basics of growth investing and talk about its possibilities and pitfalls.
Moreover, I will give you instructions which will help you find your own growth companies.
Growth investing in a nutshell
For the impatient, here’s how growth investing works:
Some companies experience constant sales growth over an extended period. Thanks to the compounding effect, their stock value will grow exponentially, assuming stock prices will roughly mirror revenues. Most such companies deliver products to a growing market segment, invent new products continuously, and have highly motivated and smart employees.
Google stock vs. Shell stock trend
Let’s start by looking at the 10-year stock history of three entities: a growth company, a value company, and a passive index.
In the period from February 2012 to Feb 2022, Google stock saw a dramatic rise of over 800%:
Compare this to Royal Dutch Shell which actually lost in value:
There are time periods where pretty much all stock moves in one direction. As a reference, we should always include the global market trend. Here we take a look at the S&P 500 index, which represents the 500 biggest US companies:
Let’s sum up our findings so far: For the last decade, Google grew significantly quicker than the market. However, Shell stock lost in value.
As you can see, there’s a huge difference in profits. How come two respectable companies who belong to the best in their respective field have such drastic difference in stock trend?
The importance of market size change
Google is well known through its services like Google Maps, YouTube, the Pixel phone, and of course Google Search. These services saw a dramatic sales increase in the last decade. On the other hand, Shell’s main business is petrol exploration and refinement, which didn’t nearly grow as much.
Let’s look at the sales trend of the two companies:
Now we get a clearer picture: Shell didn’t increase sales in the last decade, whereas Google’s sales exploded.
Now it’s time to zoom out and consider the worldwide demand for petrol. Here is how the worldwide oil consumption developed over the last decade:
Worldwide consumption increased only marginally, from 45 TWh to 50 TWh. So, the market size only increased 10% in one decade. This explains why it was pretty much impossible for Shell to be a growth company.
This leads us to the strong argument for growth investment: find an excellent company in a rapidly growing market segment, invest into that company — and sit back as your portfolio grows.
How growth investing works
The growth investing strategy proclaims that some companies experience much more sales growth than others. Moreover, the strategy claims that it is possible to foresee prolonged growth periods.
A growth company must satisfy the following criteria:
- The company should operate in a market segment that will A) grow significantly and B) offer large margins.
- The company should have a faster pace of innovation than its competitors.
- A requirement for innovation is smart engineers. Can the company attract the very best talents in its field?
- Management should have full integrity and focus on long term goals.
Finding a company which meets all 4 quality gates, is challenging and time consuming. In the coming week, I will release a new blog with a detailed description on how to find growth companies.
For now, let’s focus on the very first criteria: market size growth. Below are six market segments which will grow significantly, according to my research:
- Renewable energy production and storage — to fight climate change
- Sustainable Food — for the same reason
- Biotechnology — for personalized medicine
- Cloud computing — so companies can delegate hardware management
- Artificial intelligence — for smart products
- Social media — the world is becoming increasingly digital
Advantages of growth investing
- Resilience against temporary market disruptions: This is a long-term strategy. So unexpected market events like a recession or a change in fiscal policy will not hurt your long-term profit.
- No need to check on your portfolio every day. You can sleep without worry and check on your portfolio a year later.
- In my opinion, you can beat the market. Note though that this is a very controversial statement, there are strong proponents as well as opponents.
Disadvantages of growth investing
As always, there’s no free lunch — including the growth investment strategy. Below you can find three drawbacks of the strategy:
- More volatility: Growth stocks mostly have a high beta, which means the stock is sensitive to general market moves. In case of an unexpected personal need for quick liquidity, you might have to sell your stock at an unfavorable moment.
- You will have to work hard: Finding a company with exceptionally long future growth is extremely hard. Moreover, prices of such stocks often have future growth discounted in, so a very rigorous analysis is required.
- You will have to be patient: Growth investing only works over a long-term horizon like 5–10 years. This is not like technical analysis where you can buy today and sell tomorrow.
Discounted growth and overvalued stock
Unfortunately, growth investing is a well known strategy with many proponents and published books. As a consequence, most growth companies have already been discovered by analysists. Large parts of the investment community already expect huge growth, and this future growth is discounted in the current stock price.
I shall explain this principle with the company we already looked at: Google currently has a price to sales ratio of 7. This is far above the market average average of 3. How come this large cap? Well, most people believe Google will keep growing the way it did lately. Therefore, the current stock price has about 3 years of discounted growth included (assuming an annual growth rate of 30%). However, if this growth doesn’t materialize, you have overpaid for today’s purchase of Google stock!
Let’s recap: Most growth stocks are currently overvalued. Nevertheless, the stock price will keep growing, assuming the company keeps expanding its business at a fast pace.
Congrats, you made it to the end of this article!
This article covered the basics of growth investing. Growth investing aims at companies well positioned for future sales increase. This sales increase should last for multiple years. Being a long-term strategy, growth investing only requires initial research and no active day-to-day management. In order for you to be able to find growth companies, we covered 4 growth criteria. Among those, the most important one is a growing market size.
If you’re interested in growth investing, I am happy to announce a future blog in the coming week. This future blog will give a detailed instruction on how to find growth companies. In the meantime, I can recommend the following book on growth investing:
Common stocks, uncommon profits
Philip A. Fisher (Author)
In chapter 3, Phil gives 15 criteria for picking growth stocks.
Thanks for reading!